The Whitewing SPE is only one of the thousands of Special
Purpose Entities set up by Enron CFO Andy Fastow with the assistance of its
auditor, Andersen, and its law firm. The SPE appears to be almost
hopelessly complex to hide risk as well as hide the trail of the millions of
dollars Andy Fastow was making in double dealing at Enron.

As an educator, I find the following chart interesting
because it illustrates the hopelessness of applying the new 2003 FASB
Interpretation 46 (FIN 46) that requires tracing out the ultimate risks in deciding
whether to consolidate SPEs (that are now called VIEs by the FASB).

Power Failure: The Inside Story of the Collapse of Enron,
by Mimi Swartz, Sherron Watkins, Page 373.

WARNING:
Most portions of this document were written prior to the issuance of FASB
Interpretation No. 46 in January 2003. Most of those portions have not
been revised in light of the newer interpretation. For example, major
portions of various Emerging Issues Task Force (EITF) issues that applied prior
to January 2003, no longer apply. The affected EITF issues include EITM
Issue Numbers 10-15, 95-6, 96-21, 97-1, 97-2 and 84-30. Prior message
threads remain in this document to help historical researchers.

Deloitte and Touche provides a nice summary of FIN 46. The new interpretation
was prompted in large measure by the fraudulent use of offshore special purpose
entities (now called variable interest entities).

For technical details see the
following book:Structured Finance and Collateralized Debt Obligations: New Developments in
Cash and Synthetic Securitization (Wiley Finance) by Janet M. Tavakoli
(2008)

Questions
How many fraudulent SPEs did CFO Andy Fastow create to steal over $50 million
from his employer (Enron)?

What is most unusual and actually unethical about the way Enron's SPEs
were managed?How were these related party
dealings disclosed and yet obscured in the infamous Footnote 16 of Enron's Year
2000 Annual Report?

I have learned from some investors that there has
been a major challenge against the VIE structure of a U.S. listed Chinese
company. The challenge relates to whether the VIE can be consolidated into
the financial statements. The SEC has been aggressively examining VIE
arrangements, but I have been unable to learn whether this challenge is a
result of an SEC investigation, or who the company or auditor are.

Bear with me; this discussion has to get technical.

Under the VIE accounting rules, consolidation of
the VIE is allowed if the public company is considered to be the primary
beneficiary of the VIE (ASC 810-25-20). In a typical VIE arrangement, there
are two potential beneficiaries of the VIE: 1) the Chinese individual who
owns the shares in the VIE, and 2) the public company that has contracts
with both that individual and the VIE that transfer control and economic
interests to the public company. VIE arrangements are structured to make it
clear that all of the control and economic interest flows to the public
company.

Clear until now, anyway.

In many VIEs the founder of the company is the
owner of the VIE. The founder also usually has voting control over the
public company, which is often retained after the IPO by use of two classes
of shares. Founders typically retain voting control even if their share
holdings are reduced to a minority position. The two class of shares
approach to retaining control by founders is common in technology offerings,
most famously in Facebook. Two classes of stock are not allowed on the Hong
Kong exchange, and that presents a challenge for U.S. listed companies that
may want to move onto the Hong Kong exchange if they get kicked out of the
U.S., but that is another story.

Under typical VIE agreements, the founder agrees to
transfer his VIE shares to another VIE shareholder at the public company's
request, and to otherwise vote those shares and select VIE management at the
public company’s direction. Since the public company can remove the VIE
owner at will, it has been thought that the VIE owner has no rights, and
accordingly no interest in the VIE. Therefore the public company is the only
beneficiary of the VIE and can consolidate it into their financial
statements.

The founder, however, could stop any attempt to
remove him as the owner of the VIE since he has voting control over the
public company. With voting control, the founder has the power to elect the
board that selects, terminates and sets the compensation of management, and
establishes operating and capital decisions of the company. Do these powers
mean that the founder is actually the primary beneficiary of the VIE? If the
founder is the primary beneficiary, the public company cannot consolidate
the VIE and instead will report its share of earnings as it receives them.

What happens if the SEC or auditors decide that
this is the correct approach? Companies with this fact pattern will be
forced to deconsolidate their VIEs, and restate prior financial statements.
The VIE will drop out of the financial statements, possibly turning income
into losses in some companies, while having a minor effect on some others.

Companies affected by this are likely to
restructure their VIEs to be allowed to consolidate in the future. The easy
solution seems to be to pick someone other than the founder to own the VIE.
While that may fix the accounting problem, it introduces a huge amount of
risk. One reason that the VIE is usually held by the founder is to align the
interests of the VIE shareholder with the interests of the public
shareholders. The idea is that the founder will not steal the VIE since
doing so would destroy the value of his shares in the public company.

If the SEC is making this position clear to the
accounting firms, we could see some real surprises when companies file their
Form 20F over the next few weeks.

Question
How is the current Olympus scandal in Japan related to the Enron scandal?

At least eight Cayman Islands entities have been
linked to Olympus acquisitions that are suspected of playing a role in the
accounting scandal. Five of those no longer exist, according to a search of
the Caymans registry, which doesn’t give details on the individuals behind
the companies.

Olympus President Shuichi Takayama yesterday
said the company was looking into the role played by special purpose funds in
hiding the losses, which date back to the 1990s.

After he was fired, Woodford went public with
his concerns over the advisory fees and writedowns on three other
transactions. All involved payments to Cayman Islands companies or special purpose vehicles
whose beneficiaries are not known.

Olympus Corp.’s admission that three of its top
executives colluded to hide losses from investors fails to address the roles
played by other officials, according to the company’s biggest overseas
shareholder.

The Japanese camera maker’s shares slumped 29
percent yesterday after it reversed weeks of denials that there was any
wrongdoing in past acquisitions. The company fired Executive Vice President
Hisashi Mori over his role in covering up the losses with former Chairman
Tsuyoshi Kikukawa, who resigned last week, and said auditor Hideo Yamada
would step down.

Olympus’ biggest overseas shareholder is now
demanding investor relations head Akihiro Nambu go too because of his role
as a director of Gyrus Group Plc, the U.K. takeover target used to funnel
more than $600 million in inflated advisory fees to a Cayman Islands fund.
And after Nambu, the rest of the board must follow, said Josh Shores, a
London-based principal for Southeastern Asset Management Inc.

“Even if they didn’t know the specific details
around where payments were going and exactly why, they knew that cash was
going out the door and they also failed to raise their hands to ask
questions,” Shores said. “I don’t know who else is involved, but somebody
else is. There is a third party somewhere who received this money.”

Olympus President Shuichi Takayama yesterday said
the company was looking into the role played by special purpose funds in
hiding the losses, which date back to the 1990s.

Cayman Links

At least eight Cayman Islands entities have been
linked to Olympus acquisitions that are suspected of playing a role in the
accounting scandal. Five of those no longer exist, according to a search of
the Caymans registry, which doesn’t give details on the individuals behind
the companies.

Kikukawa, Mori and Nambu became the three directors
of Gyrus in June 2008 following the $2 billion acquisition of the U.K.
medical equipment maker in February that year. They were also directors of
three companies set up to handle the takeover, including the decision to pay
out advisory fees that amounted to more than a third of the acquisition’s
value, filings show.

Olympus declined a request to interview Kikukawa
and Mori. In six attempts to talk to Kikukawa at his home, the former
chairman didn’t appear. Mori’s home address given in U.K. filings leads to a
house under renovation in Kawasaki city, about an hour from central Tokyo.
Nobody answered the doorbell on a recent visit to Nambu’s home in a
seven-story condominium about 27 kilometers from the city center.

Japanese and U.S. regulators are probing
allegations by former chief executive officer Michael C. Woodford that more
than $1.5 billion was siphoned through offshore funds. That money may have
been used to cancel out non-performing securities that Olympus was keeping
off its books, according to a report in the Shukan Asahi magazine, which
cited people familiar with the process.

Cockroaches

Yesterday’s plunge in Olympus shares pulled other
Japanese equities lower on concerns the country hasn’t escaped corporate
governance weaknesses that have dogged it since the stock market bubble
burst at the end of 1989. Olympus shares have lost 70 percent of their value
since Woodford took his accusations public after he was axed on Oct. 14.

“Institutional investors will stay away from
Japan’s market until they confirm this is an isolated case,” said Koichi
Kurose, chief economist in Tokyo at Resona Bank Ltd. Some “investors
probably think that if there’s one cockroach, there may be 10 more,” he
said.

‘Tobashi’

Olympus’ revelations echo the practice of hiding
losses known as “tobashi” that became widespread in Japan in the late 1980s
and led to the failure of Yamaichi Securities Co., according to Yasuhiko
Hattori, a professor at Ritsumeikan University in Kyoto. Yamaichi used
overseas paper companies to hide problematic securities, until it failed in
1997 with 260 billion yen ($3.3 billion) in hidden impairments.

Takayama declined to comment on the involvement of
any securities firms in Olympus’ cover-up. The Topix Securities and
Commodity Futures Index fell 11 percent, the most of any industry group in
the broader gauge. Nomura Holdings Inc. tumbled 15 percent to the lowest in
37 years.

“There is speculation in the market that Nomura may
somehow be involved in this Olympus case,” said Shoichi Arisawa, an
Osaka-based manager at IwaiCosmo Holdings Inc. “Individual investors in
particular probably sold after seeing a high volume of Nomura’s shares being
traded.”

Nomura didn’t participate in Olympus’s concealment
of losses, said Hajime Ikeda, managing director of corporate communications
for the securities firm.

Nomura Unaware

“We are not aware of any involvement by Nomura in
Olympus’s hiding of losses in the 1990s, and we weren’t involved when
Olympus wrote off the losses” between 2006 and 2008, Ikeda said in a
telephone interview in Tokyo yesterday.

The Tokyo Stock Exchange said it’s considering
moving the shares in Olympus, the world’s biggest maker of endoscopes, to a
watchlist for possible delisting. Takayama pledged to continue with the
investigation into the losses, which he said were probably inherited by
Kikukawa.

“The investigation must continue to determine how
much rot there is,” said David Herro, chief investment officer of Harris
Associates LP. “All responsible must, at a minimum, leave. Also, since the
management’s credibility is nearly nonexistent, all of what they say must be
verified.”

Bowed in Apology

Harris held 10.9 million Olympus shares as of June
30, a 4 percent stake that makes it the company’s second-biggest overseas
investor. Southeastern had a 5 percent stake as of Aug. 16, according to
data compiled by Bloomberg.

Olympus President Takayama yesterday said he was
unaware of the hidden losses until he was told by Mori and Kikukawa the
previous evening. At the press conference, he bowed three times in seven
minutes to apologize.

In the weeks running up to his dismissal, Woodford
was engaged in an exchange of letters with Kikukawa and Mori in which he
detailed the allegations and which were copied to all member of the board.

After he was fired, Woodford went public with his
concerns over the advisory fees and writedowns on three other transactions.
All involved payments to Cayman Islands companies or special purpose
vehicles whose beneficiaries are not known.

Olympus paid a total of 73.4 billion yen to
increase stakes in Altis Co., News Chef Co. and Humalabo Co. between 2006
and 2008, which was also used to hide losses, it said yesterday. Olympus
wrote down 55.7 billion yen, or 76 percent of the acquisition value, in
March 2009, the company said in a statement Oct. 19.

“It’s beyond belief that Mr. Takayama claims he
only found out about it last night,” Woodford said in a telephone interview
yesterday. “If he didn’t know before I started writing my letters then he
should have known after.”

Enron's accounting for its
non-consolidated special-purpose entities (SPEs), sales of its own stock and
other assets to the SPEs, and mark-ups of investments to fair value
substantially inflated its reported revenue, net income, and stockholders'
equity, and possibly understated its liabilities. We delineate six
accounting and auditing issues, for which we describe, analyze, and indicate
the effect on Enron's financial statements of their complicated structures
and transactions. We next consider the role of Enron's board of directors,
audit committee, and outside attorneys and auditors. From the foregoing, we
evaluate the extent to which Enron and Andersen followed the requirements of
GAAP and GAAS, from which we draw lessons and conclusions.

The accounting issues

The transactions involving SPEs at Enron,
and the related accounting issues are, indeed, very complex. This section
summarizes some of the key transactions and their related accounting
effects. The Powers Report, a 218-page document, provides in great detail a
discussion of a selected group of Enron SPEs that have been the central
focus of the Enron investigations. While very much less detailed than the
Powers Report, the discussion in the following section (which may seem
laborious at times), supplemented with additional material that became
available after publication of the Report, should provide the reader with
insight into how Enron sought to bend the accounting rules to their
advantage. However, even a cursory review of this section will give the
reader a sense of the complex financing structures that Enron used in an
attempt to create various financing, tax, and accounting advantages.

Six accounting and auditing issues are of
primary importance, since they were used extensively by Enron to manipulate
its reported figures: (1) The
accounting policy of not consolidating SPEs that appear to have permitted
Enron to hide losses and debt from investors.
(2) The accounting treatment of sales of Enron's merchant investments to
unconsolidated (though actually controlled) SPEs as if these were arm's
length transactions. (3) Enron's income recognition practice of recording
as current income fees for services rendered in future periods and recording
revenue from sales of forward contracts, which were, in effect, disguised
loans. (4) Fair-value accounting resulting in restatements of merchant
investments that were not based on trustworthy numbers. (5) Enron's
accounting for its stock that was issued to and held by SPEs. (6)
Inadequate disclosure of related party transactions and conflicts of
interest, and their costs to stockholders.

SUMMARY: The series of events leading to questions about auditing
practices at Olympus that failed to uncover a decades-long coverup of
investment losses is highlighted in this review. The company must submit its
next financial statement filing to the Tokyo Stock Exchange by December 14,
2011 for the period ended September 30, 2011 or face delisting.

CLASSROOM APPLICATION: The review focuses on auditing questions
about sufficient competent evidence, change of auditors, and ability to
provide an audit report given knowledge of the length of time this coverup
has been ongoing.

QUESTIONS:
1. (Introductory) What fraudulent accounting and reporting
practices has Olympus, the Japanese optical equipment maker, admitted to
committing?

2. (Advanced) What services is Mr. Woodford calling for to
investigate the inappropriate payments and accounting practices by Olympus?
Specifically name the type of engagement for which Mr. Woodford thinks that
Olympus should contract with outside accountants.

3. (Introductory) Refer to the related articles. What questions
have been raised about outside accountants' examinations of Olympus's
financial statements for many years?

4. (Advanced) Based only on the discussion in the article, what
evidence did Olympus's auditors rely on to resolve their questions about the
propriety of accounting for mergers and acquisitions? Again, based only on
the WSJ articles, how reliable was that audit evidence?

5. (Advanced) What happened with Olympus's engagement of KPMG AZSA
LLC as its outside auditor? What steps must be taken under U.S. requirements
when a change of auditors occurs?

6. (Introductory) What challenges will Olympus face in meeting the
deadline of December 14 to file its latest financial statements? What will
happen to the company if it cannot do so?

SUMMARY: This review continues coverage from last week of the
accounting scandal at Olympus Corp. The Investigation Report into Olympus
Corporation and its management, written by the "Third Party Committee" hired
by the Board of Directors on October 14, 2011, is available directly online
at
http://online.wsj.com/public/resources/documents/third_party_olympus_report_english_summary.pdf
The report provides the clearest description yet of the investment loss and
accounting scandal that has brought the Japanese imaging equipment maker to
the brink of delisting from the Tokyo Stock Exchange. As described in the
opening page of the document, the Olympus Corporation Board of Directors
called for a third party review because "the shareholders and others doubted
that" payments by Olympus to a financial advisor and acquisitions by
Olympus, along with subsequent recognition of impairment losses on those
investments, were appropriate. The findings in the report essentially state
that Olympus began incurring financial losses on speculative investments
that were originally hoped to bolster corporate earnings when operating
earnings declined due to a strengthening yen in the late 1980s. "However, in
1990 the bubble economy burst and the loss incurred on Olympus by the
financial assets management increased" (p. 6). Then, in 1997 to 1998, "when
the unrealized loss was ballooning," Japanese accounting standards were
changed to require fair value reporting of financial assets, as did those in
the U.S. "In that environment, Olympus led by Yamada and Mori started
seeking a measure to avoid the situation where the substantial amount of
unrealized loss would come up to the surface..." because of this change in
accounting standards. The technique was so common in Japan that it was given
a name, "tobashi." As noted in the WSJ article, the Olympus auditors at the
time, KPMG AZSA LLC "...came across information that indicated the company
was engaged in tabshi, which recently had become illegal in Japan....[T]he
auditor pushed them...to admit to the presence of one [tobashi scheme] and
unwind it, booking a loss of 16.8 billion yen."

CLASSROOM APPLICATION: Questions relate to the accounting
environment under historical cost accounting that allows avoiding
recognition of unrealized losses and to the potential for audit issues when
management is found to have engaged in one unethical or illegal act.

QUESTIONS:
1. (Introductory) For how long were investment losses hidden by
accounting practices at Olympus Corp?

2. (Advanced) What is the difference between realized and
unrealized investment losses? How are these two types of losses shown in
financial statements under historical cost accounting and under fair value
accounting methods for investments?

3. (Introductory) What accounting change in the late 1990s led
Olympus Corp. management to search for further ways to hide their investment
losses? In your answer, comment on the meaning of the Japanese term "tobashi."

4. (Introductory) What happened in 1999 when KPMG AZSA "came across
information that indicated the company was engaged in tobashi, which
recently had become illegal in Japan"?

5. (Advanced) Given the result of the KPMG AZSA finding in 1999,
what concerns should that raise for any auditor about overall ability to
conduct an audit engagement?

The secret held for a quarter-century, quietly
passed among senior executives. Within Olympus Corp. the goal was clear.
Hide some $1.5 billion in investment losses from public view.

The toll on Olympus mounted as time went by. "The
core part of the management was rotten, and that contaminated other parts
around it."

So concluded a 200-page reported issued Tuesday,
the most complete account yet of a scandal that routed money through more
than a dozen banks, funds and investment firms around the globe, ultimately
leading to the departure of several top executives and putting the respected
optical-equipment maker on the bubble for a stock delisting.

Starting in the mid-1980s, Olympus, along with
other Japanese exporters, turned to speculative financial investments as a
way to ease the sting of a surging yen with what they believed would be easy
profits.

At Olympus, that strategy set in motion a chain of
events that were the heart of the company's accounting scandal, according to
the report, written by a six-member outside panel appointed by the company
last month.

The document, based on 189 interviews with current
and former Olympus employees and business partners, also brought into relief
the organizational problems that plague many Japanese companies: lack of
transparency, little regard for shareholder rights and reluctance to
challenge authority.

"The situation was an epitome of the salaryman
mentality in a bad sense," said the panel, referring to Japan's culture of
corporate loyalty.

Olympus on Tuesday said it "takes very seriously
the results" of the investigation and "is considering further fundamental
measures to restore confidence."

The report identified former Vice President Hisashi
Mori, his former boss in the company's accounting department, Hideo Yamada,
and two former Olympus presidents among a "select few" with knowledge of the
original investment losses, the effort to hide the losses and then the
attempts to account for them through inflated acquisition prices and
advisory fees.

Based on the report's account, Olympus's financial
troubles started with the Plaza Accord in 1985, an agreement to devalue the
U.S. dollar.

The ensuing rise in the yen dented the company's
operating profit, and its president at the time, Toshiro Shimoyama, decided
Olympus should augment its core business with zaiteku, or financial
investments.

New accounting rules governing off-balance-sheet
transactions went into effect for most companies in January. As a result, 53
large companies have already estimated that they will have put back an
aggregate $515 billion in assets to their balance sheets during the first
quarter, according to a new study of S&P 500 companies released by Credit
Suisse.

But the future state of the companies' balance
sheets remains unclear, since they only consolidated 9% of the $5.7 trillion
in off-balance sheet assets they reported in the fourth quarter of last
year. About $4 trillion of the remaining assets will be taken up on the
balance sheets of mortgage companies Fannie Mae and Freddie Mac, which
guaranteed many of the subprime residential mortgages. The rest of the
assets — about $1.2 trillion worth — could find their way to the balance
sheets of companies that have yet to claim them, or "on no one's balance
sheet," assert report authors David Zion, Amit Varshney, and Christopher
Cornett.

Because some assets are lingering in accounting
limbo or hidden by murky disclosures, gauging their final effect on company
financials could be akin to hitting "a moving target," says the report.
Indeed, Credit Suisse notes that it's unclear whether all reported estimates
issued during the first quarter included deferred taxes, loan loss
provisioning, and such off-balance-sheets assets as mortgage-servicing
rights. (Selling mortgage servicing rights is a multi-billion dollar
industry.)

The rules that force companies to put such assets
back on their balance sheets were issued in 2008 and went into effect at the
beginning of this year. They are Topic 860 (formerly FAS 166), which deals
with transfers and servicing of financial assets and liabilities, and Topic
810 (formerly FAS 167), the rule governing the consolidation of
off-balance-sheet entities in their controlling companies' financial
reports.

In reviewing the results and disclosures as of
March 11, the study's authors found that only 183 companies in the S&P 500
reported the balance-sheet effects of FAS 166 in their financial results,
with 24 providing an estimated impact and 117 reporting either no impact or
an immaterial one. Forty-two companies are still evaluating the effects of
the new rules, while 317 made no mention of the rules at all. In contrast,
342 companies disclosed the effects of FAS 167, with 29 providing estimates
and 214 registering no impact or an immaterial one. That leaves 99 companies
still evaluating the FAS 167 impact, and 158 making no mention of the
financial statement effects.

Predictably, most of the asset increases belong to
companies in the financial sector, where off-balance-sheet transactions like
securitization, factoring, and repurchase agreements are popular. As of Q4
2009, financial services companies in the S&P 500 had stashed $5.5 trillion,
and $1.6 trillion, respectively, in variable-interest entities (VIEs) and
the now-defunct qualified special-purporse entities (QSPEs). That left a
mere $110 billion in assets spread among the QSPEs and VIEs associated with
companies in nine other industries.

Assets are returning to balance sheets for several
reasons, most notably the Financial Accounting Standards Board's elimination
if QSPEs, or "Qs," in 2008, when it became apparent that the structures were
being abused. Indeed, Qs were permitted to remain off bank balance sheets if
they took a "passive" role in managing the structures' finances. But when
the subprime crisis hit, and the mortgages being held in Qs began to fail,
banks — with the blessing of regulators — took a more active role, reworking
the terms of the entities' mortgage investments. At the time, FASB Chairman
Robert Herz called Qs "ticking time bombs" that started to "explode" during
the credit crunch.

VIEs, on the other hand, are still used. These
vehicles are thinly capitalized business structures in which investors can
hold controlling interests without having to hold voting majorities. As of
the fourth quarter last year, S&P 500 companies parked $1.7 trillion worth
of assets in VIEs.

The revised standards were supposed to wreak havoc
on bank balance sheets because, among other things, the rules for keeping
loan-related assets off the books would be rewritten. At the time, bankers
expected the rewrite would force them to consolidate big swaths of assets
that were being held in VIEs and QSPEs. And consolidating the assets from
the entities would have required them to increase the amount of regulatory
capital they kept on hand — a charge to cash — and thereby reduce the amount
of lending they could do. Dampening lending during a credit crisis, argued
bankers, would hurt the recovery.

Since their enactment, the accounting rules have
affected their industry big-time. Of the companies reporting an impact, nine
purely financial-sector outfits plus General Electric account for 96% of the
$515 billion being consolidated during the first quarter, says Credit
Suisse. Of that group, which includes Bank of America, JP Morgan Chase, and
Capital One, Citigroup tops the list with an estimated $129 billion in
assets being brought back on the books in the first quarter — which
represents 7% of its existing total assets. The newly-consolidated assets
come in all shapes and sizes, says the report: $86.3 billion in credit card
loans, $28.3 billion in asset-backed commercial paper, $13.6 billion in
student loans, and $4.4 billion in consumer mortgages, for example. ($5
trillion or the $ $5.7 trillion held in VIEs and QSPEs are mortgage
related.) Citigroup also disclosed a $13.4 billion charge for setting up
additional loan loss reserves and eliminating interest lost from
consolidating the assets.

Of the companies that disclosed the
financial-statement impact, only eight estimated the increase to be more
than 5% of total assets, says Credit Suisse. Invesco was the hardest hit,
reporting the highest percentage at 55%, bringing back $6 billion worth of
assets during the first quarter. Invesco's assets are parked in
collateralized loan obligations and collateralized debt obligations.

Jensen Comment
It's about time. Bank financial statements have been "fiction" for way to long.
But the accounting and auditing rules have a long way to go for banks. A huge
problem is the way auditing firms have allowed banks to underestimate loan loss
reserves. A more recent problem with FAS 140 was uncovered by Lehman's use of
Repo 105 contracts for debt masking.

Fighting the Battle Against Off-Balance-Sheet Financing" Winning a Battle
Does Not Mean Winning a War
But it's better than losing the battle

ED/2011/4 proposes that investment entities meeting
particular criteria should be required to account for investments in their
controlled entities at fair value through profit or loss, rather than by
consolidating them. ED/2011/4 also proposes changing the availability of
the fair value option for investments in associates and joint ventures by
limiting the measurement of associates and joint ventures at fair value
through profit or loss to investment entities only.

The AASB Chairman, Kevin Stevenson expressed a
number of concerns about the proposals.

It is unusual for a member of the AASB such as
myself to express concerns about an exposure draft before submissions are
received. But I do so on this occasion because this draft raises
fundamental questions about existing requirements. In my view it could lead
to increased use of off-balance-sheet accounting, see us depart from the
concept of control and lead to unjustified changes in requirements
accounting for associates and joint ventures. The exposure draft seeks to
include in IFRS accounting practices previously used in North America and
would be a step back from the universal consolidation model that we have
followed. In this regard, I note that three IASB members have expressed
alternative views on ED/2011/4.

Until now our stance has been that if an entity controls one or more
entities, it should present consolidated financial statements because they
are most likely to provide useful information about the economic entity to
the greatest number of users. The exposure draft would replace that
information with the fair value for the investment in a certain type of
subsidiary. Will that be an improvement in Australian reporting? If fair
value of the investment provides information, would not a better answer be
disclosure of the fair value of the investment as well as consolidation?
Even if the proposals have merit, is the definition of an investment entity
robust enough to avoid exploitation?

Some might find the proposals superficially appealing because they might
reduce the task of financial reporting for a group, but respondents need to
be aware that the proposals would, as well as raising the spectre of
creative structuring, also change the exemptions from applying equity
accounting. Some entities that presently elect to fair value their
investments in associates and joint ventures would find they can no longer
do so, and this would potentially include, for example, insurers with assets
held to back investment-linked insurance contracts.

The AASB needs to hear very clearly from constituents whether this proposed
standard is in the interest of Australian reporting and if it is not
considered to be, we need to respond strongly to the IASB. I would
encourage very active consideration of the proposals.

Comments are due to the AASB by 30 November 2011 and to the IASB by 5
January 2012 and Australian constituents are strongly encouraged to
carefully review the proposals and make their views known to the AASB and
the IASB.

Background

ED/2011/4 proposes ‘investment entities’ be
required to measure investments in controlled entities at fair value through
profit or loss (rather than consolidate them). However, a non-investment
entity parent of an investment entity would be required to consolidate the
investment entity subsidiary and its controlled entities.

Continued in article

At the 2011 AAA Annual Meetings in Denver, former FASB Chairman Bob Herz
claims that unconsolidated Qualified SPEs was a good idea that became mired down
in atrocious implementations that included errors and fraud, thereby ruining the
concept of having such entities remain unconsolidated as long as fair values of
assets exceeded the fair values of the debts in the QSPEs. CFO Andy Fastow set
up over 3,000 unconsolidated SPEs and committed fraud by claiming Enron's own
equity shares were assets in those SPEs.

The FASB has published Financial Accounting
Statements No. 166, Accounting for Transfers of Financial Assets, and No.
167, Amendments to FASB Interpretation No. 46(R), which change the way
entities account for securitizations and special-purpose entities.

The new standards
will impact financial institution balance sheets beginning in 2010. The
impact of both new standards has been taken into account by regulators in
the recent “stress tests.”

These projects were initiated at the
request of investors, the SEC, and The President’s Working Group on
Financial Markets. Copies of the new standards are available at theFASB’s website,
along with a concise
briefing document.

Statement 166 is a
revision to Statement No. 140, Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities, and will require more
information about transfers of financial assets, including securitization
transactions, and where companies have continuing exposure to the risks
related to transferred financial assets. It eliminates the concept of a
“qualifying special-purpose entity,” changes the requirements for
derecognizing financial assets, and requires additional disclosures.

Statement 167 is a
revision to FASB Interpretation No. 46(R), Consolidation of Variable
Interest Entities, and changes how a company determines when an entity that
is insufficiently capitalized or is not controlled through voting (or
similar rights) should be consolidated. The determination of whether a
company is required to consolidate an entity is based on, among other
things, an entity’s purpose and design and a company’s ability to direct the
activities of the entity that most significantly impact the entity’s
economic performance.

Robert Herz,
chairman of the FASB, said:

“These changes were
proposed and considered to improve existing standards and to address
concerns about companies who were stretching the use of off-balance sheet
entities to the detriment of investors. The new standards eliminate existing
exceptions, strengthen the standards relating to securitizations and
special-purpose entities, and enhance disclosure requirements. They’ll
provide better transparency for investors about a company’s activities and
risks in these areas.”

Both new standards
will require a number of new disclosures. Statement 167 will require a
company to provide additional disclosures about its involvement with
variable interest entities and any significant changes in risk exposure due
to that involvement. A company will be required to disclose how its
involvement with a variable interest entity affects the company’s financial
statements. Statement 166 enhances information reported to users of
financial statements by providing greater transparency about transfers of
financial assets and a company’s continuing involvement in transferred
financial assets.

Both Statements 166
and 167 will be effective at the start of a company’s first fiscal year
beginning after November 15, 2009, or January 1, 2010 for companies
reporting earnings on a calendar-year basis.

FASB Statement 167: Consolidation of Variable Interest Entities

FASB
significantly revamped its consolidation standards for variable interest
entities when it released Statement No. 167 in June 2009. Those standards rework
existing rules under FIN 46R for when a company must include a VIE on its books
with a potentially huge impact on corporate balance sheets.

The criteria
for determining an entity's VIE status have shifted, based now more on a
company's "obligations" and "power" over an entity than on ownership percentage
or absorption of losses. Complicating matters further are new disclosure
requirements to explain consolidation decisions.

New standards
cover fiscal years after Nov. 15, 2009, so they affect financials published as
soon as March or April 2010. Advisors must prepare now for the standards, which
require reevaluation of existing entity relationships, regardless of whether
VIEs were previously consolidated.

How Will This Statement Change Current
Practice?
This Statement amends Interpretation 46(R) to require an enterprise to
perform an analysis to determine whether the enterprise’s variable interest
or interests give it a controlling financial interest in a variable interest
entity. This analysis identifies the primary beneficiary of a variable
interest entity as the enterprise that has both of the following
characteristics:

a. The power to direct the
activities of a variable interest entity that most significantly impact
the entity’s economic performance

b. The obligation to absorb losses
of the entity that could potentially be significant to the variable
interest entity or the right to receive benefits from the entity that
could potentially be significant to the variable interest entity.
Additionally, an enterprise is required to assess whether it has an
implicit financial responsibility to ensure that a variable interest
entity operates as designed when determining whether it has the power to
direct the activities of the variable interest entity that most
significantly impact the entity’s economic performance.

This Statement amends Interpretation
46(R) to require ongoing reassessments of whether an enterprise is the
primary beneficiary of a variable interest entity. Before this Statement,
Interpretation 46(R) required reconsideration of whether an enterprise is
the primary beneficiary of a variable interest entity only when specific
events occurred. This Statement amends Interpretation 46(R) to eliminate the
quantitative approach previously required for determining the primary
beneficiary of a variable interest entity, which was based on determining
which enterprise absorbs the majority of the entity’s expected losses,
receives a majority of the entity’s expected residual returns, or both.

This Statement amends certain guidance
in Interpretation 46(R) for determining whether an entity is a variable
interest entity. It is possible that application of this revised guidance
will change an enterprise’s assessment of which entities with which it is
involved are variable interest entities.

This Statement amends Interpretation
46(R) to add an additional reconsideration event for determining whether an
entity is a variable interest entity when any changes in facts and
circumstances occur such that the holders of the equity investment at risk,
as a group, lose the power from voting rights or similar rights of those
investments to direct the activities of the entity that most significantly
impact the entity’s economic performance.

Under Interpretation 46(R), a troubled
debt restructuring as defined in paragraph 2 of FASB Statement No. 15,
Accounting by Debtors and Creditors for Troubled Debt Restructurings,
was not an event that required reconsideration of whether an entity is a
variable interest entity and whether an enterprise is the primary
beneficiary of a variable interest entity. This Statement eliminates that
exception.

This Statement amends Interpretation
46(R) to require enhanced disclosures that will provide users of financial
statements with more transparent information about an enterprise’s
involvement in a variable interest entity. The enhanced disclosures are
required for any enterprise that holds a variable interest in a variable
interest entity. This

Statement nullifies FASB Staff
Position FAS 140-4 and FIN 46(R)-8, Disclosures by Public Entities
(Enterprises) about Transfers of Financial Assets and Interests in Variable
Interest Entities. However, the content of the enhanced disclosures
required by this Statement is generally consistent with that previously
required by the FSP.

How Will This Statement Improve
Financial Reporting?]This Statement amends Interpretation 46(R)
to replace the quantitative-based risks and rewards calculation for
determining which enterprise, if any, has a controlling financial interest
in a variable interest entity with an approach focused on identifying which
enterprise has the power to direct the activities of a variable interest
entity that most significantly impact the entity’s economic performance and
(1) the obligation to absorb losses of the entity or (2) the right to
receive benefits from the entity. An approach that is expected to be
primarily qualitative will be more effective for identifying which
enterprise has a controlling financial interest in a variable interest
entity.

This Statement requires an additional
reconsideration event when determining whether an entity is a variable
interest entity when any changes in facts and circumstances occur such that
the holders of the equity investment at risk, as a group, lose the power
from voting rights or similar rights of those investments to direct the
activities of the entity that most significantly impact the entity’s
economic performance. It also requires ongoing assessments of whether an
enterprise is the primary beneficiary of a variable interest entity. These
requirements will provide more relevant and timely information to users of
financial statements.

This Statement amends Interpretation
46(R) to require additional disclosures about an enterprise’s involvement in
variable interest entities, which will enhance the information provided to
users of financial statements.

What Is the Effect of This Statement
on Convergence with International Financial Reporting Standards?The International Accounting Standards
Board (IASB) has a project on its agenda to reconsider its consolidation
guidance. The IASB issued two related Exposure Drafts, Consolidation
and Derecognition, in December 2008 and March 2009, respectively. The
IASB project on consolidation is a broader reconsideration of all
consolidation guidance (not just the guidance for variable interest
entities).

Although this Statement was not
developed as part of a joint project with the IASB, the FASB and IASB
continue to work together to issue guidance that yields similar
consolidation and disclosure results for special-purpose entities. The
ultimate goal of both Boards is to provide timely, transparent information
about interests in specialp purpose entities. However, the timeline and
anticipated effective date of the IASB project is different from the
effective date of this Statement.

This Statement addresses the potential
impacts on the provisions and application of Interpretation 46(R) as a
result of the elimination of the qualifying special-purpose entity concept
in Statement 166. Ultimately, the two Boards will seek to issue a converged
standard that addresses consolidation of all entities.

The range of
financial malfeasance and manipulation was fast. Energy companies, such as
Dynegy, El Paso, and Williams, did the same complex financial deals
(particularly using
SPEs) Andy Fastow engineered at Enron. Telecommunication s firms, such
as
Global Crossing and WorldCom,
fell into bankruptcy after it became clear they, too, had been cooking their
books. Financial firms were victims as well as aiders-and-abettors.
PNC Financial, a major bank, settled SEC charges that it abused
off-balance-sheet deals and recklessly overstated its 2001 earnings by more
than half. A rogue trader at
Allfirst Financial, a large Irish bank, lost $750 million in a flurry of
derivatives trading that put Nick Leeson of Barings to shame. And so on, and
so on.

Question
Would you like to see (AIG) Special Purpose Vehicles pull away from the loading
($25 billion) dock?

In a move aimed at cutting American International
Group's $40 billion debt to the Federal Reserve Bank of New York by $25
billion and setting up two AIG life insurance giants as initial public
offerings, the N.Y. Fed has agreed to a debt-for-equity swap done via
special-purpose vehicles.

Under the agreement announced today, AIG will place
the equity of American International Assurance Company and American Life
Insurance Company in separate SPVs in exchange for preferred and common
shares of the vehicles. The New York Fed will get all the preferred shares
in the two SPVs, amounting to $16 billion in the AIA unit and $9 billion in
the ALICO vehicle.

The New York Fed will be paid a 5 percent dividend
on its shares, which it will get at a fairly hefty discount, until September
2013. For shares that aren't redeemed by that date, the SPVs would start
paying a 9 percent dividend.

The face value of the preferred shares represents a
percentage of the estimated fair-market value of AIA and ALICO. With the
IPOs looming, the parties aren't saying what that value is. But the New York
Fed, which will hold all the preferred shares, will get a majority stake in
the economic value of the companies.

For its part, AIG will hold all the common equity
in the two SPVs and "will benefit from the fair market value of AIA and
ALICO in excess of the value of the preferred interests as the SPVs monetize
their stakes in these companies in the future," AIG said in a release issued
today.

The dates of the closing of the deal and the IPOs
aren't tied to each other. The AIG-New York Fed transaction is expected to
close late in the third quarter of this year. AIA, which has already
launched its IPO process, is expected to start the offering in 2010. While
ALICO hasn't started the process of its offering just yet, it has announced
its attention to do so.

As for the SPVs, they will structured as
limited-liability companies in Delaware. Until they're spun off, AIA and
ALICO will remain wholly owned subsidiaries of AIG, consolidated in the
company's reported financial statements.

"Placing AIA and ALICO into SPVs represents a major
step toward repaying taxpayers and preserving the value of AIA and ALICO,
two terrific life insurance businesses with great futures," said Edward
Liddy, AIG's chairman and chief executive officer said in the release.
"Operating AIA's and ALICO's successful business models in the SPV format
will enhance the value of these franchises as we move forward with our
global restructuring."

Asked why the company chose to structure the
arrangement by means of the much stigmatized method of setting up SPVs, AIG
spokesperson Christina Pretto told CFO that since the vehicles were
on-balance-sheet entities they wouldn't be the target of disapproval.

AIA has one of the biggest books of life insurance
in Asia, and ALICO has a large presence in Japan. While both are profitable,
AIG has found it impossible to achieve its goal of selling the companies-at
least partly because they are so large.

Yesterday (April 2, 2008), FASB voted to
remove the Qualified Special Purpose Entity (QSPE) concept (used for some
securitizations) from FAS 140, Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities, and to remove the related
scope exception from FIN 46R, Consolidation of Variable Interest Entities
(VIEs). In addition to removing the QSPE concept, the board also
approved amendments to the derecognition criteria in paragraph 9 of FAS 140
(changes shown in redline form on pages 1-2 of the
board handout), and agreed to provide
guidance on the ‘unit of account’ as relates to when a ‘portion’
of an asset can be derecognized - by requiring essentially the same
characteristics as proposed in FASB’s 2005 Exposure Draft of proposed
amendments to FAS 140 with respect to the definition of ‘participating
interest,’ (definition appears on pages 3-4 of the board handout). FASB's
project page currently states an amended Exposure Draft (ED) is expected
to be released in the second quarter of 2008; in my estimation, the proposed
changes decided yesterday are likely to be included in that ED or in a
separate proposal document.

Brief Background The QSPE concept specified in
FAS 140 had been criticized, particularly in light of recent market turmoil
tied largely to origination (and related issues involving securitization) of
subprime mortgages. To obtain ‘sale treatment’ or off-balance sheet
treatment for assets transferred or sold to a QSPE, (and for asset transfers
generally) the transferor (e.g. a bank or other originator of mortgages)
must give up control over the assets, otherwise the assets would have to
remain on the transferors balance sheet (and gain on sale would be limited).
The QSPE concept as defined in FAS 140 provided a means to demonstrate
control was given up by the transferor, however, the restrictions specified
in FAS 140 prohibiting a QSPE from managing the underlying assets, unless
pre-specified in the original documents of the securitization trust, or
agreed to subsequently by a majority of the investors in the trust, was
viewed by some as threatening the ability of lenders and servicers to modify
the terms of mortgages to help borrowers avoid foreclosure in the recent
credit crunch.

Expedited Action In Light
Of Credit Crunch Responds To SEC, PWG RequestFASB has had a
longer term project to amend FAS 140,
dating back to its
2005 Exposure Draft. The expedited nature
of dealing with the QSPE issue as a short-term project was in response to a
request from the SEC that FASB address this issue by year-end (noted
on page 4 of this letterto the AICPA and FEI),
and in response to a recommendation of the President’s Working Group (PWG) -
in its March 13
report - calling on ‘authorities’ to
encourage FASB to ‘evaluate the role of accounting standards in the current
market turmoil… includ[ing] an assessment of the need for further
modifications to accounting standards related to consolidation and
securitization.’

FASB Project Manager Pat
Donoghue told the FASB board that requests had come from ‘preparers and
others’ to deal with the QSPE issue expeditiously. She explained, “We
have significant issues in practice; constituents cannot consistently apply
the guidance to products we have today.”

FASB board member Don Young
asked if the objective of the short-term project on QSPEs was solely to
provide preparer relief, or if it would improve financial reporting for
investors. FASB staff responded there are two objectives to the project, one
is short-term to respond to issues in practice that have been exacerbated by
the current market turmoil and developments in securitization since FAS 140
was written, but the longer-term objective of broader amendments to improve
FAS 140 remained.

FASB staff also recommended
that their long-term project to amend FAS 140 be tackled as a joint project
with the IASB, and could include a broad look at derecognition (e.g,
off-balance sheet or ‘sale’ treatment of securitizations and asset
transfers.) Among the issues FASB previously deliberated at board meetings
last year was whether to move to a ‘linked presentation’ model, aimed at
providing more transparency to investors by linking assets transferred with
a related liability, so investors could determine for themselves the
implications of net vs. gross treatment, vs. the current model allowing
off-balance sheet treatment.

In voting to support the FASB staff’s
proposal to remove the QSPE concept from the accounting literature, a number
of board members mentioned there were longstanding difficulties with the
QSPE concept that were exacerbated in the credit crunch relating in
particular to subprime mortgage securitizations.

“For five years now we’ve struggled with
application of [FAS] 140 [and] the fundamental question related to servicer
discretion,” said board member Larry Smith. “We said, it’s almost
impossible to structure a vehicle with the objectives the board had in mind
when they created QSPEs: that is, an entity that has no decision making
whatsoever relative to the run-out of these assets.”

He added, “I think the staff is
appropriate in recommending that we do away with QSPE’s; there are no assets
short of US treasury assets that somebody doesn’t make decisions over during
the life of [those] assets.”

“We have a concept that really isn’t
working, and we need to come up with some other way to help investors
evaluate what these transactions are,” said Smith. “At the end of the day,
I don’t think the current application of 140 is what the board that approved
140 had in mind, therefore I think we should just stop pretending, and
eliminate QSPE’s from our literature, and rely on other aspects of the
consolidation model to give [us an] answer that is appropriate.”

Among the items noted was a letterfrom SEC Chairman
Christopher Cox to House Financial Services Chairman Barney Frank on July
24, 2007. Although the letter concluded that loan modifications when default
is reasonably foreseeable “would not result in a requirement
for entities to account for those securitized assets on their balance
sheets,” the letter also included a detailed attachment from the Chief
Accountant to the SEC Chairman, which included a discussion about
permissible activities of QSPEs as set forth in FAS 140, which said,
“Many mortgage loans are securitized using QSPE structures. The FASB
intended for QSPEs to be entities that would not be actively managed and
instead would be on ‘auto pilot.’”

As we noted in this blog last year,
in trying to interpret the guidance on QSPEs set forth in FAS 140 and
expressly described in the detailed attachment to SEC’s July 24,
2007 questions were raised in some minds as to whether the general guidance
in the cover letter from SEC Chairman Cox to Rep. Frank was
‘unequivocal,’ as it had been so described in an August 23, 2007letterfrom Sen. Charles
Schumer to the CEOs of the ‘Big Four’ audit firms, as cited in thisAlertpublished August 24,
2007 by the Center for Audit Quality (CAQ).

Further guidance appeared in an SEC
letterdated Jan. 8, 2008
addressed to the AICPA and FEI, in which the SEC Chief Accountant said, “The
Office of the Chief Accountant(“OCA") has been asked by preparers, auditors,
ASF [American Securitization Forum], the U.S. Department of the Treasury,
and others whether modifications of Segment 2 subprime ARM loans that occur
pursuant to the ASF Framework would result in a change in
the status of a transferee as a qualifying special-purpose-entity ("QSPE")
under paragraph 55 of FASB Statement No. 140, Accounting for Transfers
and Servicing of Financial Assets and Extinguishments of Liabilities ("Statement 140").”

“OCA has read the ASF framework and has
concluded that it will not object to continued status as a QSPE if
Segment 2 subprime ARM loans are modified pursuant to the specific screening
criteria in the ASF Framework,” stated the SEC’s January 8 letter to the
AICPA and FEI. “Additionally, given the unique nature of the
contemplated modifications and other loss mitigation activities that are
recommended in the ASF Framework, OCA expects registrants to provide
sufficient disclosures in filings with the Commission regarding the impact
that the ASF Framework has had on QSPEs that hold subprime ARM loans.”

The SEC also stated in its January 8 letter
that its “represent[t] an interim step in addressing one practice issue that
exists in the application of paragraphs 9(b) and 35-55 of Statement 140,”
and that, “Concurrent with the issuance of this letter, OCA has requested
the FASB to immediately address the issues that have arisen in the
application of the QSPE guidance in Statement 140. OCA has requested that
the FASB complete its project addressing the guidance in paragraphs 9(b) and
35-55 of Statement 140 in order to be effective no later than years
beginning after December 31, 2008.”

Herz on Hindsight and ForesightRolling forward to yesterday’s board meeting,
FASB Chairman Robert Herz observed, “I think the [QSPE]
concept has been stretched and stretched and stretched and stretched and
stretched over the years, and the crescendo has been with the latest round
of very problematic assets that were securitized with this approach.”

He noted that although there are some very
simple structures that would qualify for QSPE treatment, “the majority of
what’s been an issue have been much larger things with assets that turned
out to be quite problematic and require a lot of attention.”

“Maybe with the benefit of hindsight we
understand that, although I think even with the benefit of foresight it
could have been maybe understood.”

Herz’ observation about hindsight and
foresight is interesting when read in conjunction with paragraphs 190 and
191 in the Basis for Conclusions section of
FAS
140.

Para. 190 noted that constituents told FASB
they believed QSPEs and their servicers should be able to exercise a “commercially
reasonable and customary amount of discretion in deciding whether to
dispose of assets in the specified circumstances,” and that “allowing a
QSPE only to have provisions that require disposal without choice raises
the risks of forcing a disposal at a bad time or that allowing no discretion
conflicts with the fiduciary duties of the SPE’s trustee or servicer.”

“The Board acknowledged the concerns
that underlie those views but did not change that provision,”
continues para. 190, “reasoning that a qualifying SPE with that flexibility
should not be considered to be a passive conduit through which its BIHs
[Beneficial Interest Holders] own portions of its assets, as opposed to
owning shares or obligations in an ordinary business enterprise.

Para. 191 noted, “The Board considered
but rejected a general condition that would permit a qualifying SPE to
sell assets as long as the sales were made “to avoid losses.” Such a
condition would have allowed an SPE to have powers to sell as long as the
primary objective was not to realize gains or maximize return, a concept
introduced in Topic D-66. The Board rejected it because it would have
given the trustee, servicer, or transferor considerable discretion in
choosing whether or not the SPE should sell if a loss was threatened.
Such discretion is more in keeping with being an ordinary business
that manages its own assets than with being a passive repository of assets
on behalf of others.”

It is always easier to look back with 20-20
hindsight, but it is interesting to observe the emphasis noted in FAS 140 as
cited above on precluding QSPEs from operating like an ‘ordinary business,’
including the ability to use discretion and manage assets to avoid or
minimize losses. In light of the current credit crisis, it is encouraging to
see the FASB responding rapidly to concerns that have been raised.

Companies, auditors and others will need to
holistically examine the package of changes being proposed to remove the
QSPE concept and the related amendments to paragraph 9 of FAS 140, to
determine the net effect on how they account for securitization
transactions, as well as the impact on how they are structured and any
accounting ramifications from modification of underlying assets.

SUMMARY: The
Securities and Exchange Commission has asked the FASB to create
rules for banks' securitization vehicles, variable interest
entities (VIEs) or special purpose entities (SPEs) by the end of
this year. On April 2, 2008, the FASB tentatively voted to do
away with the special securitization vehicles and to undertake a
joint project with the IASB on derecognition in general. The
author writes that the FASB "...didn't signal how banks would
have to account for..." SPEs. The actual implication of the
FASB's vote would be to do away with the qualifying SPE
exemptions from FASB Statement 140 and Interpretation No. 46,
Consolidation of Variable Interest Entities--an Interpretation
of ARB No. 51.

CLASSROOM
APPLICATION: Advanced Accounting courses at the Master's
level. Though some questions in this review are listed as
introductory, they are introductory to the issues of accounting
for securitization transactions, an advanced topic for any
accounting student.

QUESTIONS:
1. (Introductory) What is a "qualifying special purpose
entity?" What accounting standards and/or interpretations define
this term? Identify the names of the standards and summarize
their general requirements.

2. (Introductory) What did the FASB decide at its April
2, 2008, meeting with regard to qualifying special purpose
entities and to derecognizing items from balance sheets in
general? In your answer, define the term "derecognition." (Hint:
You may access information about FASB meetings and decisions
through the Action Alert on their web site. The Action Alert
covering Board actions on April 2, 2008, was published on April
10, 2008 and is available at http://www.fasb.org/action/aa041008.shtml

3. (Advanced) What will happen on banks' consolidated
financial statements if the special purposes entities that they
set up to own securitized assets can no longer be excluded from
the requirements of Statement of Financial Accounting Standards
No. 140, "Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities--a replacement of FASB
Statement No. 125"?

4. (Advanced) Given your answer to question #3 above,
do you agree with the author's statement in the article that,
when the FASB voted to eliminate the qualifying SPEs, "it didn't
signal how banks would have to account for them"?

5. (Advanced) In the article, the author notes that
FASB Chairman Bob Herz did not indicate that banks would be
allowed to make a net presentation of securitized assets and
liabilities on their balance sheets. How would that possibility
lead to "ballooning" of bank balance sheets? Why might banks
particularly want a net basis of presentation for securitized
assets?

6. (Introductory) In introducing this FASB decision,
the author states that changing accounting standards in this
area "could make borrowing more expensive...but [also could]
prevent the abuses that led to billions in losses over the past
year." Are accounting standards designed to elicit particular
economic responses such as limiting abuses by financial
statement preparers or losses such as those experienced after
last year's credit market failures? Support your answer.

Possible accounting rule changes spurred by the
subprime-mortgage crisis would make it harder and costlier for banks to
package and sell off loans. That could make borrowing more expensive for
consumers and companies but prevent the abuses that led to billions in
losses over the past year.

The changes come at a time of scrutiny of how
financial institutions packaged mortgages and other loans into securities,
shifting the risk of bad loans from their own balance sheets to investors.
The changes will "be a little bit like taking the punch bowl away," said
Robert Herz, chairman of the Financial Accounting Standards Board, which
sets U.S. accounting rules.

Outlining the possible shape of these new rules
during an accounting conference Thursday, Mr. Herz indicated that banks
might have to keep on their books loans they previously packaged and sold
off, or securitized.

Under current rules banks create securitization
vehicles that hold the loans off their balance sheets. The Securities and
Exchange Commission earlier this year asked the accounting board to create
rules for these vehicles by year's end.

The FASB last month tentatively voted to do away
with the special securitization vehicles, although it didn't signal how
banks would have to account for them. In his remarks, Mr. Herz indicated
banks will have to use other rules governing off-balance-sheet vehicles.
These rules are likely to be tightened as well.

Any change in the rules surrounding securitization
vehicles and other off-balance-sheet entities could have widespread
implications for banks. At the end of 2007, J.P. Morgan Chase & Co. and
Citigroup Inc. had nearly $1 trillion in assets held off their books in
special securitization vehicles. J.P. Morgan generated nearly $3.5 billion
in revenue, or about 6% of total 2007 net revenue, from administering
special securitization vehicles.

In a statement, Citigroup said, "We are actively
engaged in industrywide discussions on the development of the proposal."
J.P. Morgan declined to comment.

Mr. Herz didn't push the possibility that banks
would be allowed to show the combined effect of these vehicles' assets and
liabilities on their books. Such a linked presentation could prevent a
ballooning of bank balance sheets. He also said banks likely will face
stiffer tests overall for what can stay off their books and may have to take
into account emergency-funding arrangements they often offer to
off-balance-sheet vehicles.

Politicians
and regulators have been slow to wake up to the destructive
impact of banks on the rest of society. Their lust for profits
and financial engineering has brought us the
sub-primecrisis and possibly a
recession. Billions of pounds have been
wiped offthe value of people's
savings, pensions and investments.

Despite
this, banks are set to make
record profits (in the U.K.) and their
executives will be collecting bumper salaries and bonuses. These
profits are boosted by
preyingon customers in debt, making
exorbitant
chargesand failing to pass on the
benefit of cuts in
interest rates. Banks indulge in
insider trading, exploit
charity lawsand have sold suspect
payment protection insurancepolicies.
As usual, the annual financial reports published by banks will
be opaque and will provide no clues to their antisocial
practices.

Some
governments are now also waking up to the involvement of banks
in organised
tax avoidance and evasion. Banks have
long been at the heart of the tax avoidance industry. In 2003,
the US Senate Permanent Subcommittee on Investigations
concluded (pdf)that the development
and sale of potentially abusive and illegal tax shelters have
become a lucrative business for accounting firms, banks,
investment advisory firms and law firms. Banks use clever
avoidance schemes,
transfer pricingschemes and
offshore (pdf)entities, not only to
avoid their
own taxesbut also to help their rich
clients do the same.

The role
of banks in enabling
Enron, the disgraced US energy giant,
to avoid taxes worldwide, is well
documented (pdf) by the US Senate
joint committee on taxation. Enron used complex corporate
structures and transactions to avoid taxes in the US and many
other countries. The Senate Committee noted (see pages 10 and
107) that some of the complex schemes were devised by Bankers
Trust, Chase Manhattan and Deutsche Bank, among others. Another
Senate
report (pdf)found that resources were
also provided by the Salomon Smith Barney unit of Citigroup and
JP Morgan Chase & Co.

The
involvement of banks is essential as they can front corporate
structures and have the resources - actually our savings and
pension contributions - to provide finance for the complex
layering of transactions. After examining the scale of tax
evasion schemes by
KPMG, the US Senate committee
concluded (pdf)that complex tax
avoidance schemes could not have been executed without the
active and willing participation of banks. It noted (page 9)
that "major banks, such as Deutsche Bank, HVB, UBS, and NatWest,
provided purported loans for tens of millions of dollars
essential to the orchestrated transactions," and a subsequent
report (pdf)(page111) added "which
the banks knew were tax motivated, involved little or no credit
risk, and facilitated potentially abusive or illegal tax
shelters".

Deutsche
Bank has been the subject of a US
criminal investigationand in 2007 it
reached an out-of-court settlement with several wealthy
investors, who had been sold aggressive US tax shelters.

Some
predatory practices have also been identified in other
countries. In 2004, after a six-year investigation, the
National Irish Bankwas fined £42m for
tax evasion. The bank's personnel promoted offshore investment
policies as a secure destination for funds that had not been
declared to the revenue commissioners. A government report found
that almost the entire former senior management at the bank
played some role in tax evasion scams. The external auditors,
KPMG, and the bank's own audit committee were also found to have
played a role in allowing tax evasion.

In the UK,
successive governments have shown little interest in mounting an
investigation into the role of banks in tax avoidance though
some banks have been persuaded to inform authorities of the
offshore accountsheld by private
individuals. No questions have been asked about how banks avoid
their taxes and how they lubricate the giant and destructive tax
avoidance industry. When asked "if he will commission research
on the levels of use of offshore tax havens by UK banks and the
economic effects of that use," the chancellor of the exchequer
replied: "There are no plans to
commission research on the levels of use of offshore tax havens
by UK banks and the economic effects of that use."

Continued in article

Jensen Comment
Prem Sikka has written a rather brief but comprehensive summary of many of the
bad things banks have been caught doing and in many cases still getting away
with. Accounting standards have be complicit in many of these frauds, especially
FAS 140 (R) which allowed banks to sell bundles of "securitized" mortgage notes
from SPE's (now called VIEs) using borrowed funds that are kept off balance
sheet in these entities called SPEs/VIEs. The FASB had in mind that responsible
companies (read that banks) would not issue debt in excess of the value of the
collateral (e.g., mortgage properties). But FAS 140 (R) fails to allow for the
fact that collateral values such as real estate values may be expanding in a
huge bubble about to burst and leave the bank customers and possibly the banks
themselves owing more than the values of the securities bundles of notes. Add to
this the frauds that typically take place in valuing collateral in the first
place, and you have FAS 140 (R) allowing companies, notably banks, incurring
huge losses on debt that was never booked due to FAS 140 (R).

SUMMARY: This
article addresses a proposed bailout plan for $100 billion
of commercial paper to maintain liquidity in credit markets
that have faced turmoil since July 2007, and the fact that
this bailout "...raises two crucial questions: Why didn't
investors see the problems coming? And how could they have
happened in the first place?" The author emphasizes that
post-Enron accounting rules "...were supposed to prevent
companies from burying risks in off-balance sheet vehicles."
He argues that the new rules still allow for some
off-balance sheet entities and that "...the new rules in
some ways made it even harder for investors to figure out
what was going on."

CLASSROOM
APPLICATION: The bailout plan is a response to risks and
losses associated with special purpose entities (SPEs) that
qualified for non-consolidation under Statement of Financial
Accounting Standards 140, Accounting for Transfers and
Servicing of financial Assets and Extinguishments of
Liabilities, and Financial Interpretation (FIN) 46(R),
Consolidation of Variable Interest Entities.

QUESTIONS:
1.) Summarize the plan to guarantee liquidity in commercial
paper markets as described in the related article. In your
answer, define the term structured investment vehicles (SIVs).

2.) The author writes that SIVs "...don't get recorded on
banks books...." What does this mean? Present your answer in
terms of treatment of qualifying special purpose entities (SPEs)
under Statement of Financial Accounting Standards 140,
Accounting for Transfers and Servicing Financial Assets and
Extinguishments of Liabilities.

3.) The author argues that current accounting standards make
it difficult for investors to figure out what was going on
in markets that now need bailing out. Explain this argument.
In your answer, comment on the quotations from Citigroup's
financial statements as provided in the article.

4.) How might reliance on "principles-based" versus
"rules-based" accounting standards contribute to solving the
reporting dilemmas described in this article?

5.) How might the use of more "principles-based standards"
potentially add more "fuel to the fire" of problems
associated with these special purpose entities?

The CDO imbroglio that has enveloped the financial
sector created quite a stir in 2007. Mortgage foreclosures have led to
losses for the banks, and investors in CDOs have been surprised by the
degree of their risk exposure. "Super seniors" have not been super or
senior.

Amid this disarray, a simple question has to be
asked: why are the activities and transactions of special purpose entities (SPEs),
legal entities that run collateralized debt obligations (CDOs) and similar
financial vehicles, not displayed on the financial reports of corporate
America? These SPEs remain hidden from view and corporate disclosures about
them mist like a Chicago fog.

Recall that Enron's episodes were sprinkled with
many an SPE shenanigan. The old accounting rule said that if the SPE had at
least 3 percent of its total capital from some outside source, then the
business enterprise did not have to consolidate the SPE with its own
affairs. While EITF 90-15 originally applied to certain leasing activities,
business managers quickly applied it to all sorts of SPEs, and the Financial
Accounting Standards Board and the Securities and Exchange Commission
allowed them to do so. The threshold was so low that managers found it easy
to keep SPE debt off the balance sheet and to make few disclosures.

Because of Enron, FASB finally updated the rules to
require consolidation unless outsiders contributed at least 10 percent of
the capital to the SPE and this capital is at risk. Funny, FASB sat on its
collective backside for over a decade before it took action. It seems the
board members are incapable of taking proactive steps in any area.

One of the criticisms was that 3 percent equity
does not really put the equity at risk. While the 10 percent cutoff remains
arbitrary, it clarifies the situation -- until the board muddied this
clarity with some mystical, principles-based goobledy-gook. Many managers
complained because they perceived that billions of dollars would be added to
the corporate balance sheet. Apparently the appeals had some effect, for
FASB modified the final rule. Interpretation No. 46R now states:

9. An equity investment at risk of less than 10
percent of the entity's total assets shall not be considered sufficient to
permit the entity to finance its activities without subordinated financial
support in addition to the equity investment unless the equity investment
can be demonstrated to be sufficient. The demonstration that equity is
sufficient may be based on either qualitative analysis or quantitative
analysis or a combination of both. Qualitative assessments, including but
not limited to the qualitative assessments described in paragraphs 9(a) and
9(b), will in some cases be conclusive in determining that the entity's
equity at risk is sufficient. If, after diligent effort, a reasonable
conclusion about the sufficiency of the entity's equity at risk cannot be
reached based solely on qualitative considerations, the quantitative
analyses implied by paragraph 9(c) should be made. In instances in which
neither a qualitative assessment nor a quantitative assessment, taken alone,
is conclusive, the determination of whether the equity at risk is sufficient
shall be based on a combination of qualitative and quantitative analyses.

a. The entity has demonstrated that it can
finance its activities without additional subordinated financial
support.

b. The entity has at least as much equity invested as other entities
that hold only similar assets of similar quality in similar amounts and
operate with no additional subordinated financial support.

c. The amount of equity invested in the entity exceeds the estimate of
the entity's expected losses based on reasonable quantitative evidence.

Note that the 10 percent threshold can be ignored
under several scenarios using either quantitative or qualitative excuses. As
I said in 2003, this rule or standard is suspect and board members are
spineless. The debt of an SPE is similar to the debt of a subsidiary. If
FASB thinks that SPE debt does not have to be consolidated, it might as well
announce that parent companies no longer have to show the liabilities of
their subsidiaries.

We can forget substance over form. While we are at
it, we might as well toss out decision usefulness and relevance because FASB
really doesn't promote these ideals, despite the rhetoric in the so-called
conceptual framework.

Given the ethical failures of both managers and
auditors, I predicted in Hidden Financial Risk (2003) that many SPEs would
remain unconsolidated. Indeed the majority of SPEs not only remain
unconsolidated, but also the sponsoring organizations provide precious
little disclosures about them. With the help of investment bankers,
corporate managers have been highly creative in finding rhetoric that skirts
principled accounting. When the corporate executives are managers of the
investment banks, well, the creativity is off the charts.

Years ago FASB and the SEC should have required the
consolidation of SPEs. The last six months or so have clearly displayed the
need for improved corporate reporting. This directive applies to the
sponsors of CDOs including Citicorp and Merrill Lynch: they should
consolidate their special purpose vehicles.

How many more debacles in the market place will
occur before FASB and the SEC get it right? When will they have men and
women of courage?

The module below is not
in the above online version
of the above article.
However, it is on Page 51 of
the printed version.

UNEQUAL TREATMENT

IF THE FEDERAL
RESERVE BOARD AND THE SECURITIES AND EXCHANGE Commission pursue the same
agenda, why were Merrill Lynch & Co. and the Canadian Imperial Bank of
Commerce (CIBC) treated so differently by the Corporate Fraud Task Force--a
team with representatives from the SEC, the FBI, and the Department of Justice
(DoJ) set up to prosecute perpetrators of Enron's fraud--than were Citigroup
and J. P. Morgan Chase & Co.? After all, all four banks did much the
same thing.

Under settlements
signed with the SEC last July, Citigroup and Chase were fined a mere $101
million (including $19 million for its actions relating to a similar fraud
involving Dynegy) and $135 million, respectively, which amounts to no more
than a week of either's most recent annual earnings. And they agreed, in
effect, to cease and desist from doing other structured-finance deals that
mislead investors. That contrasts sharply with the punishment meted out
by the DoJ to Merrill and CIBC, each of which not only paid $80 million in
fines, but also agreed to have their activities monitored by a supervising
committee that reports to the DoJ. Even more striking, CIBC agreed to
exit not only the structured-finance business but also the plain-vanilla
commercial--paper conduit trade for three years. No regulatory agency
involved in the settlements would comment on the cases, though the SEC's
settlement with Citigroup took note of the bank's cooperation in the
investigation.

But Brad S. Karp, an
attorney with the New York firm Paul, Weiss, Rifkind, Wharton & Garrison
LLP, suggested recently that the terms of the SEC settlement with its client,
Citigroup, reflected a lack of knowledge or intent on the bank's part.
As Karp noted more than once at a February conference on legal issues and
compliance facing bond-market participants, the SEC's settlement with
Citigroup was ex scienter, a Latin legal phrase meaning "without
knowledge."

However, the SEC's
administrative order to Citigroup cited at least 13 instances where the bank
was anything but in the dark about its involvement in Enron's fraud.

As Richard H. Walker,
former director of the SEC's enforcement division and now general counsel of
Deutsche Bank's Corporate and Investment Bank, puts it, all the banks involved
in Enron's fraud "had knowledge" of it. Yet Walker isn't
surprised by their disparate treatment at the hands of regulators.
"The SEC does things its way," he says, "and the Fed does them
another." *Ronald Fink and Tim Reason

When the Financial Accounting Standards Board released
its exposure draft of new accounting rules for special-purpose entities (SPEs),
in late 2002, the nation's financial regulators sent FASB chairman Robert H.
Herz decidedly mixed signals.

On the one hand, the Securities and Exchange
Commission wanted Herz to make the rules effective as soon as possible. SPEs
were the prime vehicle for the fraud that brought Enron down, and were widely
used by other companies to take liabilities off their balance sheets, obscure
their financial condition, and obtain lower-cost financing than they deserved.
Not surprisingly, the SEC was anxious to head off other financial fiascos
resulting from such abuse.

At the same time, however, the Federal Reserve Board
pressed Herz to slow down. That's because the new rules threatened to
complicate the lives of the Fed's most important charges: large, multibusiness
bank holding companies that happen to earn sizable fees by arranging deals
involving SPEs. Stuck between this regulatory rock and hard place, Herz told
the Fed and the SEC to get together and work out a timetable that satisfied
both constituencies.

And they did. But the rules, known as
FIN 46 (FASB Interpretation No. 46), have only recently taken effect in
some cases, and have yet to do so in others. While the delay in the rules'
effective date may reflect the complexity of the transactions covered by FIN
46 as much as the controversy generated by the rules themselves, the conflict
between the Fed and the SEC over the matter stems from a deeper problem: the
Fed and the SEC have very different regulatory missions that can sometimes
come into serious conflict.

The problem surfaced in December 2002 during
congressional hearings on the extensive role that certain banks—including
Citigroup, J.P. Morgan Chase & Co., and Merrill Lynch & Co.—played
in deceptive transactions involving Enron SPEs. Those hearings by the Senate
Permanent Subcommittee on Investigations, led by Sen. Carl Levin (D-Mich.),
identified what he and then­ranking minority member Sen. Susan M. Collins
(R-Maine) termed "a current gap in federal oversight" of the banks
that helped them aid and abet Enron's fraud. "The SEC does not generally
regulate banks, and bank regulators do not generally regulate accounting
practices overseen by the SEC," notes the report, which went on to say
that this "is a major problem and needs immediate correction."

That correction has yet to be made. The onus of doing
so is on the Fed, as the chief regulator of the nation's financial system. Yet
Fed chairman Alan Greenspan shows little inclination to do much about the
problem.

Yes, the markets have recovered from Enron, at least
for the time being. But the penalties and other punishment that regulators
meted out to the banks for their role in the fraud display at best a worrisome
inconsistency. And that suggests that problems arising from the regulatory gap
identified by senators Levin and Collins could recur. Unless the gap is
closed, it could undermine other regulatory efforts aimed at improving
corporate governance. That, in turn, might have a short-term impact on
investor confidence, still fragile some two years after Enron's failure. And
in the long term, future Enrons could slip through the gap undetected.

If nothing else, the question of what should be done
about it deserves a place on the agenda when the Senate considers Greenspan's
nomination for a fifth term, as is expected after his current four-year stint
ends in June.

No Firewalls
To be sure, both Citigroup and Chase agreed, after their role at Enron was
exposed, to avoid new financing arrangements that pose similar legal and
reputational risk. And under FIN 46, all deals involving SPEs must be
disclosed on the balance sheet of either the bank, the borrower, or a third
party. But it remains to be seen how effective the new rules will be in
preventing future off-balance-sheet frauds (see "Longer
Paper Routes").

Complicating matters is the combination of commercial
and investment banking and insurance blessed by the Gramm-Leach-Bliley Act of
1999, which ended the last vestiges of separation enacted by the Glass-Steagall
Act and made the Fed the financial system's primary regulator. But while the
central bank supervises private banks involved in these lines of business,
including Citigroup and Chase, the Fed's primary interest isn't stopping
financial fraud, but making sure the U.S. banking system remains safe and
sound. "The Fed doesn't even believe in firewalls," says Dimitri B.
Papadimitriou, president of the Levy Economics Institute at Bard College.

Warning: In
quotations you will sometimes find the 3% outsider minimum investment requirement
in an SPE. In Year 2002 following the Enron/Andersen scandals, the FASB raised this
to 10%. See FIN 46 below. But FAS 167 in
2009 greatly altered the revised FIN 46 such that the 10% rule has been changed.

EITF = Emerging Issue
Task Force of the Financial Accounting Standards Board
(FASB). The EITF evaluates emerging issues in financial reporting and makes
recommendations to the FASB regarding whether new or modified accounting standards are
needed do to emerging issues. For example, the issuance of FAS 13 resulted in
emerging issues raised by banks and leasing companies regarding the heavy-handed impact of
FAS 13 on certain types of leases. The EITF is a large body that is comprised of
many constituents, notably representatives from industry who often raise the issues.
The EITF issues pronouncements that are accounting guides prior to ultimate
resolution of the FASB.

There is no comprehensive FASB standard on SPE
accounting. Most of the guidelines for this accounting lies in various EITF
guidelines. The EITF guidelines are not standards, but they have a significant
impact since auditing firms often insist that these guidelines be followed by their
clients. The clients such as General Electric, General Motors, and other large
financing companies often play a key role in setting EITF guidelines and concerns about
conflicts of interest in EITF guidelines are matters of concern. A February 12, 2002
message from Eckman, Mark S, CFCTR [meckman@att.com] reads
as follows:

The SPE module (Bob Jensen's SPE
Overview) is very good. I would like to add a couple of notes on the composition of
the EITF to understand how we arrived at this point.

Since the inception of the EITF,
11 participants represent a 'Who's Who' of financial services and
companies that have major stakes in financial services.

Name

Firm

John R. Edman

General Motors Corporation

Bernard R. Doyle

General Electric Company

Philip D. Ameen

General Electric Company

Susan S. Bies

First Tennessee National Corporation

Peter E. Jokiel

CNA Insurance Companies

Thomas E. Jones

Citicorp

Paul B. Lukens

CIGNA Corporation

Kathy F. Zirolli

Aetna, Inc.

Marc D. Oken

NationsBank Corporation

David H. Sidwell

J.P. MorganChase

Gaylen N. Larson

Household International, Inc.

Also, three previous members
of the EITF have moved to positions on the FASB, including the current Chair.
Considering a total population of only 85 participants, these are rather significant
representations.

While the profession has begun to
address the independence of the auditor and auditee on a serious basis, vested
interests abound that have not been discussed.

SPE = Special Purpose Entity
that allows "sponsor/originator" companies bearing as much as 90% of the SPE's
debt risk to keep that debt off the consolidated balance sheet under U.S. Generally
Accepted Accounting Principles. Enron's double dealing former CFO Andy Fastow and
former CEO Jeff Skilling changed the definition of SPE to S _ _ t Piled Everywhere!
But the majority of SPEs in the world are perfectly legitimate. Special SPE
accounting arose largely due to pressures from banks and leasing companies to provide a
way to avoid capitalization (booking) of special types of leases following the FAS 13
change in leasing rules that stiffened the requirements for booking of "capital"
leases. There are some financing and tax benefits of SPEs, although the primary
motivation is often to achieve off-balance sheet financing (OBSF). Not all SPEs
involve lease financing, but the motivation usually is to achieve some form of OBSF
accounting.

In the simplest of terms a SPE is an entity that operates like its
own separate fund or business apart from its main beneficiary like Enron
that created it. Unlike typical subsidiary corporations, SPEs do
not have to be consolidated in the financial statements of the
beneficiary.

The SEC is the accounting standard setter that first
allowed SPE accounting off the books. The main reason is that this
allows certain types of ventures that might not otherwise be entered
into in cases where the ventures make economic sense. The key
theoretical condition of an SPE is that the current liquidation value of
its assets should exceed its debt. The idea is that nobody gets
hurt badly if the SPE is liquidated.

A very confusing requirement was imposed that an outside
investor (independent of the beneficiary) must put up at least 3% of the
value of the SPE, thereby cushioning the blow if an SPE is liquidated
somewhat below its debt obligations.After the Enron
fiasco, the FASB accounting standard setter raised this limit to 10% but did not go so far as to ban off-book SPE entities. Entire
industries were formed because the SEC allowed SPEs to keep debt off the
books, especially the entire industry of synthetic leasing.
Harsher actions by the SEC or the FASB would destroy these entire
industries.

The abuse of SPEs arises when the assets of the SPE are
not genuine assets, not sufficiently liquid, and/or are overvalued
relative to debt obligations. Having volatile financial
instruments and/or derivative financial instruments may be problematic
as assets if they are subject to huge value fluctuations in the markets.
Andy Fastow violated the SPE rules by having Enron (in a complicated
way) becoming its own sham "outside" investor and in having Enron's own
common stock as the main asset of Enron's SPEs hedging its own stock
value.
Enron's very complex, actually unfathomable, SPEs are summarized at
http://news.findlaw.com/hdocs/docs/enron/sicreport/chapter1.pdf

AccountingWEB US - Oct-2-2002 -
The Financial Accounting Standards Board (FASB) issued
Statement No. 147 on "Acquisitions of Certain Financial
Institutions" and held a roundtable discussion on accounting for
special purpose entities (SPEs).

FAS 147. Statement 147 fills in one
of the gaps left when FASB issued Statements No. 141, "Business
Combinations," and No. 142, "Goodwill and Other Intangible
Assets." The new standard revises portions of Statement 72,
which was developed as a "practical solution" to avoid
creating reported earnings from purchase accounting in times when
interest rates were at historical highs and many financial
institutions were reporting losses. An article
written by FASB practice fellow Brian Degano answers frequently
asked questions about the project.

SPEs. Separately, on September 30,
FASB held a roundtable discussion on accounting for special purpose
entities. According to press
accounts, opinion was divided on the need for a speedy
resolution of the matter versus the need for a thorough review of
the issues. Securities and Exchange Commission (SEC) Deputy Chief
Accountant Jackson Day stressed the need for speed. But Stephen
Brookshire, managing principal of Atlantic Financial Group, likened
the standard-setting initiative to "taking a bazooka to
bird-hunting." Other concerns focused on the proposed effective
date of March 15, 2003, which coincides with SEC filing deadlines
for calendar-year companies, along with the potential need to
consolidate an SPE, then later deconsolidate it due to a change in
investors. ("SEC: Imperative to finalize new SPE accounting
rules by year-end," Wall Street Journal, September 30, 2002.)

SPV = Special Purpose Vehicle
that will be viewed as a synonym for SPE in this document.

VIE = Variable Interest Entity. VIE is now the
term now used by the FASB in place of the older term SPE. Since the crash
of Enron, SPE has had a negative connotation. The FASB now prefers the
term VIE to depict a special entity in which the developing sponsor may have a
varying interest in the financial risk.

QSPE = Qualified Special Purpose
Entity under the FAS 140 Standard. QSPEs enjoy special privileges under FAS
140, but must meet a number of qualification criteria. One of these is that QSPEs may not
exercise an impermissible degree of discretion in managing the assets which they hold,
which are the principal source of cash flows supporting payments on the related
securities. Aside from OBSF motivations, there are real economic incentives
that may arise due to the following possibilities that make SPEs and SPVs
"special"::

The financial risk of the sponsor of may be
limited to its investment or explicit recourse obligation in the SPE or SPV. In many
instances, creditors of a bankrupt SPE or SPV cannot seek additional assets from the
sponsor beyond what was invested or contracted for by that sponsor. In other words,
the sponsor may not become the deep pockets for damages exceeding the assets of the SPE or
SPV. The verb "may be" is not as strong as "cannot be."
The reason is that the contracts between the sponsor and the SPE or SPV may be
quite complex and obtain conditional clauses that obligate the sponsor to provide
additional assets or its own stock when certain "trigger events" take place that
require early liquidation or other actions to protect creditors of the SPE or
SPV.

The net assets of the SPE or SPV may be protected
from creditors of its sponsors such that the SPE or SPV is not the deep pockets in the
event that any sponsor goes bankrupt. This protection sometimes allows the SPE or
SPV to obtain financing at a lower cost than the sponsor can obtain financing.

Jurors who were
about to weigh J. P. Morgan Chase's $965 million claim against 11 insurers
over Enron oil and gas trades said yesterday that they had been split
before the opponents in the lawsuit reached a settlement. The insurers
agreed on Thursday to a settlement that allowed them to pay $503 million
to $579 million on six surety bonds, ending a monthlong trial in federal
court in Manhattan just as jury deliberations were to begin. Four of the
six jurors said in a group interview that they had been divided on whether
the insurers should pay and had expected to spend days deciding the
outcome. The trial showed that the insurers and J. P. Morgan Chase, whose
shares rose 6 percent after the settlement, failed to do enough research
about the risks of the oil and gas transactions, the jurors said. The
dispute was part of the fallout from the accounting scandal that led to
Enron's collapse and bankruptcy more than a year ago.

"These are
big boys and they both should have settled it instead of wasting
everybody's time," Gary Tannenbaum, a juror who works in real estate
management, said of the J. P. Morgan Chase suit. "It's sort of
embarrassing to me that big business is conducting business the way that
they did." Under the settlement, the insurers could pay the bank as
much as $579 million in cash, or they could pay $503 million and assign
their Enron bankruptcy claims to the bank. Ten of 11 insurers opted for
the lower payments. A spokesman for the Fireman's Fund Insurance Company,
a unit of Allianz, could not immediately provide details of the company's
plans.

The bank's
shares rose 50 cents, to $25.94. J. P. Morgan Chase sued to force the
insurers to pay the bonds. The insurers claimed they were tricked into
backing disguised loans between the bank and Enron that looked like
commodity trades. The trades involved Mahonia Ltd., a bank-sponsored
"special purpose vehicle" in the
Channel Island

Credit Enhancements = contractual terms in
the SPE contract that provide a sponsor's guaranteed minimum net asset value of the SPE.
Because of credit enhancements needed to either obtain SPE loans or reduce the cost
of these loans, the sponsor's assets are not generally totally shielded from SPE default
litigation. The terms of the enhancements themselves determine what the ultimate
sponsor's risk is in a worst-case scenario.

Synthetic Lease = a financing structured
to be treated as a lease for accounting purposes and a loan for tax purposes. The
structure is used by corporations that are seeking OBSF reporting of their asset based
financing, and that can efficiently use the tax benefits of owning the financed asset.

Structured Financing/Transaction
= the isolation of assets and obligations in a "structure" apart from the main
operations of sponsors. The structure is typically called a SPE or SPV.
It's cost of capital may differ from that of the sponsors, and the sponsors' control over
the structure is generally much more limited than in the case of unstructured
financings. Often the management of the SPE or SPV is contracted to a trustee who
must be independent of the sponsors. The trustee's discretion, in turn, is limited
to certain types of transactions such a mortgage investing, project construction, project
leasing, etc. The following types of structures are most common in practice:

Each sponsor factors (sells) ownership of actual
assets (e.g., receivables "factoring") to the structure. Assets are
deleted from the sponsor's balance sheet. Multiple sponsors may use the same SPE
such as when banks sell mortgage investments to a "mortgage pool" SPE.
Initially, SPE cash used to purchase the assets generally comes from the 3% (now 10%)
invested by the SPE's independent, up-front investor who is totally independent of
the SPE sponsors/originators. Cash used to purchase more assets later on from a
sponsor may come from cash flows (e.g., interest income) generated from the SPE's assets,
sales of its assets, or borrowing by the SPE. Contractual limits may be placed upon
SPE asset sales, borrowing, and securitization. A drawback of cash
flow structures is that gains reported on asset sales are taxable.

The sponsors record the transfer
of the assets as a
sales under FAS 140 or other GAAP rules. Gains and losses are based upon estimated
fair value at the time of the transfer. This is an area of great concern to auditors
since some sponsors like Enron corporation estimate fair values well above realistic fair
values and, thereby, beef up their own earnings per share with questionable levels of
recorded sales to SPEs. This is one of the alleged abuses of SPEs by Enron and other
energy traders who revised previous financial reports following the media publicity of
questionable fair value estimates.

The transferred assets are protected from lawsuits
against the sponsor, although the sponsors may have to add more "assets" based
upon contractual trigger events. Trigger events such as the severe declines in the
net value of an SPE may require that sponsors add more assets and/or their own equity
shares to the SPE.

The transferred assets may serve as security
(securitization) for borrowing by the SPE, and the cash flows from the assets and
borrowings may be used to purchase additional assets from the sponsors.

Some SPEs may purchase equity shares of the sponsor for cash, or equity shares may be
directly transferred to cover trigger event declines in an SPE's net asset value.
Transferred sponsors' equity shares become "assets" of the SPE that in turn have
their own contractual triggers. As long as equity shares can be sold for immediate
cash in the stock market at prices exceeding callable SPE debt, no crisis arises from
holding equity shares of sponsors.

For example, it is alleged that the collapse of Enron would not have arisen in late 2001
had Enron share prices not fallen below $80 per share. Plunging share prices hit SPE
trigger points below $80 per share that allowed the SPEs' creditors to demand early
collections on an SPEs' debt. The Enron shares held by some SPEs could not be sold
for sufficient cash to cover the early terminations.

Enron was strapped for cash and could not cover the triggered obligations with its own
corporate cash. Enron SPEs became a house of stacked cards based upon Enron share
prices. Enron SPEs did not have sufficient assets aside from Enron shares to cover
the called-in debt. This problem was exacerbated by Enron's inflated sales values
for transferred receivables and by collection (bad debt) difficulties in many of the
transferred receivables.

Since the only thing available to cover the decline in SPE asset values was Enron share
values, this created what the infamous Enron whistle blower (Ms Watkins) called not having
real "skin" to keep the SPEs from failing when creditors called in the debt
under contracted trigger events.

This is an example of a case where there is economic benefit (because of achieving fixed
rate debt at a lower rate than would otherwise be available without the SPE) and the
cosmetic benefit (of not having the long-term, fixed rate debt ever be booked as a
liability on the sponsor's balance sheet.)

Derivatives Financial Instrument Structure
in Lieu of an Asset Transfer

As an example, suppose that a sponsor enters into forward sales contracts for product
from a plant such as Enron's forward energy sales contracts in India for an enormous new
power plant built by Enron. Suppose the plant is originally financed with
floating rate, short-term debt until the plant begins to generate electricity.

Once the plant is operational, the sponsor's forward contracts (one type of
derivative instrument) can be transferred to an SPE that in turn uses these forward
contracts as collateral to borrow an enormous amount of cash on fixed rate notes at having
a lower rates than the sponsor could otherwise obtain on its own (because the sponsor's
other debt raises the cost of capital, whereas the SPE is shielded from the sponsor's
other creditors). After using the sale proceeds to pay off construction loan,
the sponsor (e.g., Enron) no longer has floating rate interest risk and retains title to
the plant, although the plant itself may have to serve as additional collateral to obtain
the fixed rate debt. For example, Enron's forward sales contracts in India were
reneged upon (not necessarily without good reason given the questionable way they were
obtained), and Enron itself declared bankruptcy leaving the recovery of the construction
loans by banks in doubt until the courts in the U.S. and India decide how to reimburse
creditors for the construction loans.

If the Enron's venture had proceeded according to plan, SPE's sponsor (Enron) would
receive cash from the sale of the forward contracts, and then pay off its short-term,
floating rate construction debt with this cash. The sponsor, thereby, has achieved
OBSF financing of its enormous power plant through the use of forward sales contract
derivative financial instruments. When the SPE's long-term, fixed-rate debt is paid
off, the SPE goes out of business and energy sales revenue not needed to service debt or
pay off the outside SPE investor reverts back to the sponsor. The entire venture,
thereby, if financed off balance sheet once the power plant commences producing
electricity.

When the forward sales contracts mature over time, those energy sales at forward prices
are used to service the SPE fixed rate debt. In Enron's case, India ultimately
objected to the high forward prices negotiated by an official who received many valuable
personal perks from Enron.

Various other types of derivative instruments such as swaps might be used to obtain
similar objectives.

This is an example of a case where there is economic benefit (because of achieving fixed
rate debt at a lower rate than would otherwise be available without the SPE) and the
cosmetic benefit (of not having the long-term, fixed rate debt ever be booked as a
liability on the sponsor's balance sheet. Risk and returns are probably not a whole
lot different than if the power plant had been sold to the SPE (as illustrated above for a
cash flow structure instead of a derivative financial instruments structure).

Diamond Structure

A diamond structure arises when
three or more sponsors form an SPE where no one sponsor has control over
the SPE. This type of SPE is common when the sponsors can provide
securitization with long-term throughput or take--or-pay
contracts. Diamond structures may be separate corporations
that not even meet the definition of a SPE and yet function exactly like
an SPE.

For example, suppose three major
oil companies (sponsors) want to build a pipeline. A pipeline
corporation is formed with each sponsor owning a third of the voting
shares. The sponsors invest little if any cash in the pipeline
company. However, the pipeline company can borrow millions or even
billions based upon long-term throughput contracts signed by the partners
to purchase millions of gallons of fuel carried each year in the completed
pipeline.

The throughput contracts are
essentially forward contracts to purchase throughput, revenues from which
go to service the pipeline's debt and to operate the pipeline.
Similar contracts can arise with take-or-pay contracts such as long-term
purchasing contracts from a new oil refinery.

Defeasance (In Substance
Defeasance)

Defeasance OBSF was invented over
20 years ago in order to report a $132 million gain on $515 million in
bond debt. An SPE was formed in a bank's trust department
(although the term SPE was not used in those days). The bond debt
was transferred to the SPE and the trustee purchased risk-free government
bonds that, at the future maturity date of the bonds, would exactly pay
off the balance due on the bonds as well as pay the periodic interest
payments over the life of the bonds.

At the time of the bond transfer,
Exxon captured the $132 million gain that arose because the bond interest
rate on the debt was lower than current market interest rates. The
economic wisdom of defeasance is open to question, but its cosmetic impact
on balance sheets became popular in some companies until defeasance
rules were changed first by FAS 76 and later by FAS 125.

Exxon removed the $515 million in
debt from its consolidated balance sheet even though it was technically
still the primary obligor of the debt placed in the hands of the SPE
trustee. Although there should be no further risk when the in
substance defeasance is accomplished with risk-free government bond
investments, FAS 125 in 1996 ended this approach to debt
extinguishment. FASB Statement No. 125 requires derecognition of a
liability if and only if either (a) the debtor pays the creditor and is
relieved of its obligation for the liability or (b) the debtor is legally
released from being the primary obligor under the liability. Thus, a
liability is not considered extinguished by an in-substance defeasance.

In-Substance Defeasance
Controversy Arises Once Again

From The Wall Street
Journal Accounting
Educators' Reviews on
January 16, 2004

SUMMARY: The article
describes several points
apparent from Parmalat's
financial statements that,
in hindsight, give reason to
have questioned the
company's actions.
Discussion questions relate
to appropriate audit steps
that should have been taken
in relation to these items.
As well, financial reporting
for in-substance defeasance
of debt is apparently
referred to in the article
and is discussed in two
questions.

QUESTIONS:
1.) Describe the signals
that investors are purported
to have missed according to
the article's three authors.

2.) Suppose you were the
principal auditor on the
Parmalat account for
Deloitte & Touche. Would
you have noted some of the
factors you listed as
answers to question #1
above? If so, how would you
have made that assessment?

3.) Why do the authors
argue that it should have
been seen as strange that
the company kept issuing new
debt given the cash balances
that were shown on the
financial statements?

4.) Define the term
"in-substance
defeasance" of debt.
Compare that definition to
the debt purportedly
repurchased by Parmalat and
described in this article.
How did reducing the total
amount of debt shown on its
balance sheet help
Parmalat's management in
committing this alleged
fraud?

5.) Is it acceptable to
remove defeased debt from a
balance sheet under USGAAP?
If not, then how could the
authors write that, "at
the time, accountants and
S&P said that [the
accounting for Parmalat's
debt] was strange, but that
technically there was
nothing wrong with it"?
(Hint: in your answer,
consider what basis of
accounting Parmalat is
using.)

Synthetic Lease Structure (Sponsors Sell
the Asset to the SPE and Then Lease It Back)

A common approach is for the sponsor to sell the
asset to the SPE and then lease it back from the SPE via what is known as synthetic
leasing. A synthetic lease is structured under FAS 140 rules such that a
sale/leaseback transaction takes place where the fair value of the assets "sold"
can be reported by the sponsor as "revenue" for financial reporting. In a
synthetic lease, this "revenue" does not have to be reported up-front for tax
purposes even though it is reported up-front for financial reporting purposes.

Proceeds from the sale to an SPE in this instance
are generally long-term receivables rather than cash (which is the primary reason the sale
revenues are not taxed up-front).

The synthetic leaseback terms are generally such
that the sponsor does not have to book the leased asset or the lease liability under FAS
13 as a capital lease (i.e., some clause in the lease contract allows the asset to be
kept off balance sheet as an operating lease). Hence the financing of the lease
asset remains off balance sheet. This is one ploy used by airlines and oil companies
to keep assets and "debt" off the balance sheet as well as deferring taxes.

If the SPE actually manages the transferred assets
(e.g., a pipeline or a refinery), then throughput or take-or-pay contracts may take the
place of leasing.

The US Financial Accounting Standards Board has
submitted its response to the SEC Staff Report on Off-Balance Sheet
Arrangements, Special Purpose Entities, and Related Issues released by
the US Securities and Exchange Commission in June 2005. The SEC report was
prepared pursuant to the Sarbanes-Oxley Act of 2002 and was submitted to the
President and several Congressional committees. The SEC staff report
includes an analysis of the filings of issuers as well as an analysis of
pertinent US generally accepted accounting principles and Commission
disclosure rules. The report contains several recommendations for
potentially sweeping changes in current accounting and reporting
requirements for pensions, leases, financial instruments, and consolidation:

Pensions: The staff recommends
the accounting guidance for defined-benefit pension plans and
other post-retirement benefit plans be reconsidered. The trusts
that administer these plans are currently exempt from
consolidation by the issuers that sponsor them, effectively
resulting in the netting of assets and liabilities in the
balance sheet. In addition, issuers have the option to delay
recognition of certain gains and losses related to the
retirement obligations and the assets used to fund these
obligations.

Leases: The staff recommends
that the accounting guidance for leases be reconsidered. The
current accounting for leases takes an 'all or nothing' approach
to recognizing leases on the balance sheet. This results in a
clustering of lease arrangements such that their terms approach,
but do not cross, the 'bright lines' in the accounting guidance
that would require a liability to be recognized. As a
consequence, arrangements with similar economic outcomes are
accounted for very differently.

Financial instruments: The
staff recommends the continued exploration of the feasibility of
reporting all financial instruments at fair value.

Consolidation: The staff
recommends that the Financial Accounting Standards Board
continue its work on the accounting guidance that determines
whether an issuer would consolidate other entities – including
SPEs – in which the issuer has an ownership or other interest.

Disclosures: The staff believes
that, in general, certain disclosures in the filings of issuers
could be better organized and integrated.

FASB's response discusses a number of
"fundamental structural, institutional, cultural, and behavioral forces"
that it believes cause complexity and impede transparent financial
reporting. FASB provides an update on its activities and projects intended
to address and improve outdated, overly complex accounting standards. These
areas include accounting for leases; accounting for pensions and other post
employment benefits; consolidation policies; accounting for financial
instruments; accounting for intangible assets; and conceptual and disclosure
frameworks. The FASB also identifies several other initiatives aimed at
improving the understandability, consistency, and overall usability of
existing accounting literature, through codification, by attempting to stem
the proliferation of new pronouncements emanating from multiple sources, and
by developing new standards in a 'principles-based' or 'objectives-oriented'
approach. Click to download:

FIN 46 made companies admit
paternity of SPEs (now called Variable Interest Entities by the FASB). But
it also resulted in some surprise adoptions of SPEs/VIEs.

FASB Statement 167: Consolidation of Variable Interest Entities

FASB
significantly revamped its consolidation standards for variable interest
entities when it released Statement No. 167 in June 2009. Those standards rework
existing rules under FIN 46R for when a company must include a VIE on its books
with a potentially huge impact on corporate balance sheets.

The criteria
for determining an entity's VIE status have shifted, based now more on a
company's "obligations" and "power" over an entity than on ownership percentage
or absorption of losses. Complicating matters further are new disclosure
requirements to explain consolidation decisions.

New standards
cover fiscal years after Nov. 15, 2009, so they affect financials published as
soon as March or April 2010. Advisors must prepare now for the standards, which
require reevaluation of existing entity relationships, regardless of whether
VIEs were previously consolidated.

How Will This Statement Change Current
Practice?
This Statement amends Interpretation 46(R) to require an enterprise to
perform an analysis to determine whether the enterprise’s variable interest
or interests give it a controlling financial interest in a variable interest
entity. This analysis identifies the primary beneficiary of a variable
interest entity as the enterprise that has both of the following
characteristics:

a. The power to direct the
activities of a variable interest entity that most significantly impact
the entity’s economic performance

b. The obligation to absorb losses
of the entity that could potentially be significant to the variable
interest entity or the right to receive benefits from the entity that
could potentially be significant to the variable interest entity.
Additionally, an enterprise is required to assess whether it has an
implicit financial responsibility to ensure that a variable interest
entity operates as designed when determining whether it has the power to
direct the activities of the variable interest entity that most
significantly impact the entity’s economic performance.

This Statement amends Interpretation
46(R) to require ongoing reassessments of whether an enterprise is the
primary beneficiary of a variable interest entity. Before this Statement,
Interpretation 46(R) required reconsideration of whether an enterprise is
the primary beneficiary of a variable interest entity only when specific
events occurred. This Statement amends Interpretation 46(R) to eliminate the
quantitative approach previously required for determining the primary
beneficiary of a variable interest entity, which was based on determining
which enterprise absorbs the majority of the entity’s expected losses,
receives a majority of the entity’s expected residual returns, or both.

This Statement amends certain guidance
in Interpretation 46(R) for determining whether an entity is a variable
interest entity. It is possible that application of this revised guidance
will change an enterprise’s assessment of which entities with which it is
involved are variable interest entities.

This Statement amends Interpretation
46(R) to add an additional reconsideration event for determining whether an
entity is a variable interest entity when any changes in facts and
circumstances occur such that the holders of the equity investment at risk,
as a group, lose the power from voting rights or similar rights of those
investments to direct the activities of the entity that most significantly
impact the entity’s economic performance.

Under Interpretation 46(R), a troubled
debt restructuring as defined in paragraph 2 of FASB Statement No. 15,
Accounting by Debtors and Creditors for Troubled Debt Restructurings,
was not an event that required reconsideration of whether an entity is a
variable interest entity and whether an enterprise is the primary
beneficiary of a variable interest entity. This Statement eliminates that
exception.

This Statement amends Interpretation
46(R) to require enhanced disclosures that will provide users of financial
statements with more transparent information about an enterprise’s
involvement in a variable interest entity. The enhanced disclosures are
required for any enterprise that holds a variable interest in a variable
interest entity. This

Statement nullifies FASB Staff
Position FAS 140-4 and FIN 46(R)-8, Disclosures by Public Entities
(Enterprises) about Transfers of Financial Assets and Interests in Variable
Interest Entities. However, the content of the enhanced disclosures
required by this Statement is generally consistent with that previously
required by the FSP.

How Will This Statement Improve
Financial Reporting?]This Statement amends Interpretation 46(R)
to replace the quantitative-based risks and rewards calculation for
determining which enterprise, if any, has a controlling financial interest
in a variable interest entity with an approach focused on identifying which
enterprise has the power to direct the activities of a variable interest
entity that most significantly impact the entity’s economic performance and
(1) the obligation to absorb losses of the entity or (2) the right to
receive benefits from the entity. An approach that is expected to be
primarily qualitative will be more effective for identifying which
enterprise has a controlling financial interest in a variable interest
entity.

This Statement requires an additional
reconsideration event when determining whether an entity is a variable
interest entity when any changes in facts and circumstances occur such that
the holders of the equity investment at risk, as a group, lose the power
from voting rights or similar rights of those investments to direct the
activities of the entity that most significantly impact the entity’s
economic performance. It also requires ongoing assessments of whether an
enterprise is the primary beneficiary of a variable interest entity. These
requirements will provide more relevant and timely information to users of
financial statements.

This Statement amends Interpretation
46(R) to require additional disclosures about an enterprise’s involvement in
variable interest entities, which will enhance the information provided to
users of financial statements.

What Is the Effect of This Statement
on Convergence with International Financial Reporting Standards?The International Accounting Standards
Board (IASB) has a project on its agenda to reconsider its consolidation
guidance. The IASB issued two related Exposure Drafts, Consolidation
and Derecognition, in December 2008 and March 2009, respectively. The
IASB project on consolidation is a broader reconsideration of all
consolidation guidance (not just the guidance for variable interest
entities).

Although this Statement was not
developed as part of a joint project with the IASB, the FASB and IASB
continue to work together to issue guidance that yields similar
consolidation and disclosure results for special-purpose entities. The
ultimate goal of both Boards is to provide timely, transparent information
about interests in specialp purpose entities. However, the timeline and
anticipated effective date of the IASB project is different from the
effective date of this Statement.

This Statement addresses the potential
impacts on the provisions and application of Interpretation 46(R) as a
result of the elimination of the qualifying special-purpose entity concept
in Statement 166. Ultimately, the two Boards will seek to issue a converged
standard that addresses consolidation of all entities.

Lessons Not Learned from Enron
Bad SPE Accounting Rules are Still Dogging Us

From The Wall Street Journal Accounting Weekly Review on October 19,
2007

SUMMARY: This
article addresses a proposed bailout plan for $100 billion
of commercial paper to maintain liquidity in credit markets
that have faced turmoil since July 2007, and the fact that
this bailout "...raises two crucial questions: Why didn't
investors see the problems coming? And how could they have
happened in the first place?" The author emphasizes that
post-Enron accounting rules "...were supposed to prevent
companies from burying risks in off-balance sheet vehicles."
He argues that the new rules still allow for some
off-balance sheet entities and that "...the new rules in
some ways made it even harder for investors to figure out
what was going on."

CLASSROOM
APPLICATION: The bailout plan is a response to risks and
losses associated with special purpose entities (SPEs) that
qualified for non-consolidation under Statement of Financial
Accounting Standards 140, Accounting for Transfers and
Servicing of financial Assets and Extinguishments of
Liabilities, and Financial Interpretation (FIN) 46(R),
Consolidation of Variable Interest Entities.

QUESTIONS:
1.) Summarize the plan to guarantee liquidity in commercial
paper markets as described in the related article. In your
answer, define the term structured investment vehicles (SIVs).

2.) The author writes that SIVs "...don't get recorded on
banks books...." What does this mean? Present your answer in
terms of treatment of qualifying special purpose entities (SPEs)
under Statement of Financial Accounting Standards 140,
Accounting for Transfers and Servicing Financial Assets and
Extinguishments of Liabilities.

3.) The author argues that current accounting standards make
it difficult for investors to figure out what was going on
in markets that now need bailing out. Explain this argument.
In your answer, comment on the quotations from Citigroup's
financial statements as provided in the article.

4.) How might reliance on "principles-based" versus
"rules-based" accounting standards contribute to solving the
reporting dilemmas described in this article?

5.) How might the use of more "principles-based standards"
potentially add more "fuel to the fire" of problems
associated with these special purpose entities?

Early in his tenure as chairman of the Financial
Accounting Standards Board, while the Enron scandal was raging, Robert Herz
was confronted on Capitol Hill by a senator from the South. As Herz tells it,
imitating the lawmaker's distinctive drawl, the senator demanded to know when
FASB was going to "outlaw the use of these dummy co-poh-ray-shuns."

Clearly, the senator had no use for Wall Street's
preferred term, special purpose entities (SPEs). And he had a point: Corporate
America was indeed lousy with paper companies that no one seemed to own.
Enron, it had just been discovered, had used SPEs to avoid taxes and hide
mountains of debt. But how could regulators distinguish those from the
vehicles routinely used on Wall Street?

Herz's solution was FASB Interpretation No. 46 (FIN
46), an economic test designed to fill in when legal definitions of ownership
fail. The crux of the test: who stands to gain or lose the most from an SPE
whose ownership is otherwise unclear? (Such SPEs are now dubbed variable
interest entities, or VIEs.) Whichever company proves to be the VIE's
"primary beneficiary," said FASB, must consolidate the entity's
financial data in its own statements.

Since it was first issued in January 2003, FIN 46 has
dramatically reduced the number of orphaned entities. But recently it has also
resulted in a few adoptions that FASB never saw coming — at least
officially. As a result, some CFOs have found themselves saddled with
unwelcome new responsibilities of corporate parenthood.

No More Make-Believe Before FIN 46, the orphan status
of SPEs was a large part of what made them so useful. Generally speaking, SPEs
are dummy corporations, created to own assets that a company doesn't want on
its own books for any of a variety of reasons. For example, for securitization
purposes, an SPE increases the value of the assets as collateral by sheltering
them from the company's creditors. As long as their "sponsor"
company didn't have voting control or too large an equity stake, SPEs were
considered independent.

As it turned out, Enron broke even those rules. But
in the post-Enron environment, even SPEs long considered legitimate smelled
bad to investors. Whatever the stated reason for doing so, keeping assets and
liabilities off the balance sheet was hardly transparent.

Today, FIN 46 seems to be having the desired effect.
Although no comprehensive impact study has been done, a sample of 300
quarterly reports reviewed by CFO shows that companies are now claiming
ownership of many assets and liabilities that common sense has long said
belong to them. And apart from the banking industry, which went through a
torturous restructuring rather than put billions in securitized assets on bank
balance sheets, most companies have quietly accepted the change.

Still, it's no easy task to define when one company
controls another, as evidenced by the uproar in fast-food chains when the new
standard was issued. "When FIN 46 first came out, people started thinking
that franchisers might have to consolidate many of their franchisees,"
says David Thrope, a partner at Ernst & Young. But FASB's December 2003
revision of the rule, FIN 46R, put the franchisers at ease by stating that it
did not apply to "businesses" that met certain standards as defined
by FASB. (Still, a substantial debt or equity stake in another business can
result in consolidation, as seen in the recent consolidations of franchisees
by 7-Eleven and others.)

Power Struggles Nonetheless, FIN 46 has resulted in
some cases in which companies are understandably surprised to find themselves
"owning" another business. Take Sempra Energy, the parent of
California utility San Diego Gas and Electric. For the most part, the effects
of the standard on Sempra were routine — the company put a $630 million
synthetic lease back on its balance sheet and took a $26 million hit to income
when it consolidated a money-losing company in the United Kingdom.

Continued in the article

Implicit
Variable Interests
"Statement by SEC Staff: Remarks before
the 2005 AICPA National Conference on Current SEC and PCAOB Developments," by
Mark Northan U.S. Securities and Exchange Commission Washington, DC December 5,
2005 ---
http://www.sec.gov/news/speech/spch120505mn.htm

Implicit Variable Interests Changing topics now,
another area that I would like to highlight is the identification of
implicit variable interests when applying FIN 46(R).

At this conference last year, Jane Poulin briefly
mentioned the need to consider "activities around the entity when applying
FIN 46(R) and that certain types of activities could impact both the
determination of whether an entity is a variable interest entity as well as
identification of the primary beneficiary.7

The FASB staff addressed some of these issues
earlier this year when they issued a staff position on implicit variable
interests.8 This FSP provides guidance for determining when activities
around the entity would cause a reporting enterprise to have a variable
interest. The FSP describes an implicit variable interest as an interest
that absorbs or receives the variability of an entity indirectly rather than
through contractual interests in the entity.9 The guidance does not however
provide a "bright-line for determining when an implicit variable interest
exists. Instead, the FSP indicates that such determinations are a matter of
judgment and will depend on the relevant facts and circumstances.10

At the end of the FSP, the FASB staff provides one
comprehensive example of the how the FSP should be applied. In that example
a company leases an asset from an entity that is entirely owned by a related
party. Under the FSP, the lessee company would hold an implicit interest in
the lessor company if it effectively guaranteed the related party's
investment.

The guidance on implicit variable interests is
important for a number of reasons. In particular, it helps meet the
objective in FIN 46(R) that variable interest entities should be
consolidated by a company that has a majority of the risks and rewards.11 It
also prevents registrants from circumventing the provisions of FIN 46(R) by
absorbing variability indirectly such as through an arrangement with another
interest holder rather than directly from the entity.

With these thoughts in mind, I would like to
highlight a few things about implicit variable interests. First, while much
of the discussion in the FSP focuses on the example of a noncontractual
interest in a leasing transaction between related parties, it is important
to note that implicit interests can also result from contractual
arrangements with unrelated variable interest holders. For instance, we
recently evaluated a registrant's conclusion that it was not the primary
beneficiary of a variable interest entity because it did not have any
interest in the entity whatsoever. However, following several inquiries from
the staff it became clear that the registrant had entered into contractual
agreements with several of the variable interest holders that effectively
protected those holders from absorbing a significant amount of the entity's
variability. In this circumstance, we concluded that the contractual
agreements with the variable interest holders were implicit interests in the
variable interest entity. The registrant was, in fact, absorbing a majority
of the expected losses through those implicit interests and was therefore
the primary beneficiary despite having no direct contractual interest in the
variable interest entity.

Consistent with the FASB staff's guidance, we
believe that identification of implicit variable interests is a matter of
judgment that depends on individual facts and circumstances. Again, there
are no "bright-line tests that can be applied to easily identify these
arrangements. However, with this in mind, registrants should consider the
following questions in evaluating whether or not a contractual arrangement
with a variable interest holder is an interest in the entity:

Was the arrangement entered into in contemplation
of the entity's formation?

Was the arrangement entered into contemporaneously
with the issuance of a variable interest?

Why was the arrangement entered into with a
variable interest holder instead of with the entity?

And lastly, did the arrangement reference specified
assets of the variable interest entity?

While answers to these questions might not provide
definitive conclusions for every circumstance, we believe that they will
provide a good starting point for evaluating whether an implicit variable
interest exists.

FIN 46, the new consolidation guidance, is as broad
as it is complex (see TRAS, 4/21/03). One of its biggest challenges is that it
introduced a new “variable-interest entity” (VIE) consolidation model, a
departure even from earlier versions of the standard.

Audit partners say the standard is hard to apply and
difficult to understand (specifically paragraph 5).

FASB Senior Project Manager Ron Lott replies that the
Board continues to work with the accounting profession for clarification.
Indeed, the Staff has just posted seven proposed Staff positions on FIN 46
(see, FASB site), with comments due back May 26.

Going through the FIN 46 litmus tests

The VIE model is set up to help companies filter
in/out which entities come under FIN 46’s scope. SPEs are only a subsection,
according to Mike Joseph, a partner with Ernst & Young.

Almost anything can be a “variable interest,”
including management fees, derivatives and debt investments.

To decide whether or not a company is a
variable-interest entity, an investor needs to follow the following set of
litmus tests:

Step 1: Is it a voting rights entity? (If yes,
existing GAAP applies; if no, FIN 46 applies). Entities that are not VIEs are
voting-rights entities. So if an entity is a “legitimate” voting-rights
entity, it’s not a VIE, and hence outside the scope of FIN 46.

Step 2: Is the equity right for “real?” (If yes,
apply current accounting. If no, FIN 46 kicks in). Anything that US GAAP “catalogues”
as equity—regardless of voting rights—counts as equity under FIN 46. (Note
that this will change with Phase 1 of equity/liabilities.) Just because the
“interest” is equity-like, however, does not scope the holder out of FIN
46. To qualify as “legit” the equity investment at risk:

• Has to be sufficient (so that the business can
fund itself without additional subordinated debt); and

• Has to bestow substantial decisionmaking powers
on its holder.

There are three ways to prove that there’s
sufficient equity at risk:

(1) Show that the entity has outstanding only senior
debt;

(2) Compare its capital structure to like entities;
or

(3) Run a probabilistic calculation of expected
loss/gain and demonstrate that the equity is sufficient to absorb possible
losses. (Of the three above, experts say that the third is likely to be most
commonly used.)

Interestingly, there’s no longer a bright line (a
3-percent rule) to demonstrate sufficiency. While a 10-percent rule had been
rumored, and is even mentioned in the rule, regardless of the percentage
companies still must pass one of the three tests above. “Hence that
10-percent line ends up being rather superfluous,” says Mr. Joseph.

To qualify as a “decisionmaker,” the equity
holder must be able to affect substantive decisions, for example buy or sell
assets or affect the revenue and losses of the business. Being able to vote on
trivial matters won’t cut it.

Next, who’s the primary beneficiary?

Having flunked the test above (the equity is not in a
voting-rights entity), the investor concludes by default that it’s holding a
variable interest.

The actual investment vehicle can vary. “In essence
anything that represents a cash call or an obligation to absorb risk in an
entity, be it a loan, derivative contract, management agreement, equity, debt,
etc., can be a variable interest,” Mr. Joseph notes. What matters for
consolidation purposes, however, is whether the variable-interest holder is
the primary beneficiary (or PB). If, after going through the test below, the
investor concludes that it’s not the PB, then it will account for the
interest under current GAAP rules, depending on the “type” of instrument
that it’s holding.

The definition of PB is a unique FIN 46 concept.
Basically, it means the party that has to consolidate the entity. To figure
out who’s the PB, investors have to determine:

• Who has over 50 percent of the potential loss; or

• Who has over 50 percent of the potential residual
value; or

• Who has both.

Not every VIE will have a PB. Potential gains may be
allocated to multiple investors, keeping each under the 50 percent mark (which
for practical purposes defines majority).

Ironically, if a loss is shared among several
investors, but a single investor stands to gain more than 50 percent, that
investor is the PB. (For the purpose of calculating the gain/loss, holders
must also include any fixed and variable management fees.)

What’s potentially confusing is that FIN 46 does
not apply traditional “financial” concepts of gain and loss to make that
determination. Rather, loss/gain are measured as probable outcomes above or
below the probable expected return on the investment.

So, to figure out who stands to gain/lose and by how
much, investors would start out with an assumption about the most likely
return, and then calculate probable outcomes above or below that line. The one
that has over 50 percent “wins.”

One more thing to keep in mind: Just because one
investor in a VIE has concluded it’s the PB does not automatically exempt
others from consolidation. The analysis has to happen for every single
investor—separately.

Where accountants see uncertainty, lawyers may spot
room for discretion/flexibility. Such is the case with the FASB’s recently
published consolidation guidelines, Financial Interpretation No. 46, or FIN
46.

Accounting pros say that the new guidelines are
complex and further reaching than many treasurers had anticipated (see TRAS,
5/5/03). While this is true, there may be a silver lining: The conceptual
rather than “bright-line” approach may allow companies some room for
discretion.

Understanding the model

At the heart of FIN 46 is a model that helps
companies determine which entities come under its scope (variable-interest
entities, or VIEs), and under what set of circumstances an investor has to
consolidate a previously off-balance-sheet item.

Under FIN 46, investors holding a stake in a VIE need
to determine (each independently) whether or not they are the primary
beneficiary (i.e., stand to absorb more than 50 percent of the loss or gain,
or both). The primary beneficiary has to consolidate the entity.

An interesting issue raised by recent analysis
published by NY law firm, Clifford Chance, concerns the legal status of FIN
46, as an “interpretation” rather than a financial standard.

As such, the law firm notes, “it’s drafted more
as a conceptual statement than a rule.” This means there may well be
substantial uncertainty pre-implementation. But, by the same token, “as an
interpretation, it probably will be applied more flexibly than a rule would
be.”

One area of possible flexibility (read: discretion)
is the calculation of expected losses and returns in order to determine the
primary beneficiary.

This loss/gain concept is based on present-valued
cash flows under various possible scenarios; it also requires that investors
begin by deciding on the “most likely” outcome, using some probabilistic
analysis. All this, obviously, is beyond the typical accounting analysis. “Thus,
we can expect much discussion and negotiation over expected losses and
expected residual returns.”

International accounting standards, currently vague
on the issue of SPE accounting (see story), won’t be so for much longer. At
its mid-July meeting, the IASB discussed consolidation accounting and how it
applies to Special Purpose Entities, in light of the FASB’s new draft
interpretation (see TRAS, 7/15/02).

The IASB wants to see a comprehensive standard that
would cover consolidation of both SPEs and non-SPEs.

And, in general, it agrees with the direction of the
FASB’s path, in defining variable interests and primary beneficiaries as
guides to consolidation, when the existence of control is not obvious using
traditional methods.

The IASB plans to meet with the FASB and other rule
makers in late July to discuss consolidation issues and plans to issue a a
project plan at a subsequent Board meeting.

Moving forward on options

Meanwhile, as the US Congress struggles with whether
or not corporate reform bills should include a change in how companies account
for employee stock options (unlikely, since the subject, a perennial hot
potato, is way too hot in today’s market environment), the IASB has
instructed its staff to draft a standard that basically takes up the expensing
approach.

The IASB has concluded that companies should not have
the option, as they do under US GAAP, to avoid immediate expensing. The
expected effective date for the new rule is fiscal years beginning after
January, 2004.

If Congress fails to act, the emergence of a new IASB
rule may give the FASB the impetus it needs to affect change in US rules as
well (see story).

Some US MNCs (e.g., Coke) recently announced they
will voluntarily begin to expense employee stock options in their income
statements. “None have the same share price volatility that we do, however,”
notes the treasurer of a high-tech company. Valuation issues, meanwhile, are
still murky.

Some investment banks, however, are reportedly
working on creative equity hedging structures that would help mitigate the
impact expensing might have on a company’s P&L.

Under censure from the SEC for compromising its independence AIG
accounting fraud, Ernst & Young agreed to pay up
$1.5 million to clients of AIG in 2007.

From The Wall Street Journal Accounting Weekly Review
on March 30, 2007

SUMMARY: Ernst
& Young (E&Y) "was censured by the
Securities and Exchange Commission (SEC) and
will pay $1.5 million to settle charges that
it compromised its independence through work
it did in 2001 for clients American
International Group Inc. and PNC Financial
Services Group. "Regulators claimed AIG
hired E&Y to develop and promote an
accounting-driven financial product to help
public companies shift troubled or volatile
assets off their books using special-purpose
entities created by AIG." PNC accounted
incorrectly for its special purpose entities
according to the SEC, who also said that
"PNC's accounting errors weren't detected
because E&Y auditors didn't scrutinize
important corporate transactions, relying on
advice given by other E&Y partners.

QUESTIONS:
1.) What are "special purpose entities" or
"variable interest entities"? For what
business purposes may they be developed?

2.) What new interpretation addresses issues
in accounting for variable interest
entities?

3.) What issues led to the development of
the new accounting requirements in this
area? What business failure is associated
with improper accounting for and disclosures
about variable interest entities?

4.) For what invalid business purposes do
regulators claim that AIG used special
purpose entities (now called variable
interest entities)? Why would Ernst & Young
be asked to develop these entities?

5.) What audit services issue arose because
of the combination of consulting work and
auditing work done by one public accounting
firm (E&Y)? What laws are now in place to
prohibit the relationships giving rise to
this conflict of interest?

Recent moves by the FASB in response to negative
comment on FIN 46 follow a familiar pattern.

Scope creep is often a problem when accounting
guidance attempts to tackle complex problems like off-balance sheet entities
or derivatives. Just like when FAS 133 was first introduced to put all
derivatives on the balance sheet almost everything came to be viewed as a
potential derivative (or something with a potential derivative embedded in
it); so too has FIN 46’s effort to put off-balance sheet entities (SPEs) on
someone’s balance sheet ended up casting a wide net. The FASB’s initial
attempts to define SPEs as Variable Interest Entities (VIEs), subject to
consolidation tests that would put such structures on the balance sheets of
their primary beneficiaries, similarly and, arguably, purposefully cast a wide
net with a tight mesh, so as to not let any sought after fish get away.

After considerable push back from firms who did think
they had anything resembling SPEs (including many franchise operations), like
with FAS 133's derivatives, the scope of entities subject to FIN 46 is being
refined. In particular, those so-called VIEs that are established for a
business purposes, e.g., JVs and franchises, and not as financial structures,
distinguishing them from what the SEC’s Chief Accountant calls “the SPEs
of old,” have been reconsidered and the non-SPEs will now be scoped out for
the most part. Further, constinuents will have more time to make sense of the
changes, but only for non-SPE VIEs (see deferral of effective date below).

SPEs or “SPEs of old” have now been
"defined" by the FASB as those entities to which enterprises would
have previously applied the relevant accounting literature for pre FIN 46 SPEs,
which would include EITF Issue No.’s 90-15, 96-20, 97-1, and Topic No. D-14.

This is an important and instructive outcome, showing
how the FASB allows comment (and other forms of constituent input) to come up
with logical counterarguments to its tentative guidance, which tends to narrow
and loosen the wide and tight nets it casts in response to calls to improve
financial reporting. All the more reason that due process is important and
comment by knowledgeable constituents is critical.

The scope change and other modifications to FIN 46
will be issued shortly in a new FIN 46-R. To help everyone involved make sense
of these changes, and the FSP that continue to be issued, the effective date
for FIN 46-R has been delayed, until the end of Q1/04 for most firms (see
below). However, and it is an important one, the application of FIN 46 to “SPE’s
of old” has not been delayed--much to the dismay of the Bond Market
Association/American Securization Forum and others. The effectiveness of
comment and the ability to change the FASB's collective mind does have its
limits.

Major scope change

At the December 10 board meeting, the FASB came to
the significant decision to scope out many of the business-oriented VIEs from
FIN 46. Per the FASB’s release, the Board decided to:

Provide that an enterprise need not apply
Interpretation 46 to an entity that is a business as to be defined in the
final Interpretation, unless one of more of the following conditions exist,
(Other generally accepted accounting principles would apply to such entities):

The reporting enterprise and its related parties*
were involved in the formation of the entity. However, this condition would
not apply if the entity is an operating joint venture under joint control of
the reporting enterprise and one or more independent parties [franchises will
be included as well in this exception, per the December 17 meeting].
Substantially all of the activities of the entity involve or are conducted on
behalf of the reporting enterprise or its related parties. The reporting
enterprise and its related parties provide more than half of the equity,
subordinated debt or other forms of subordinated financial support to the
entity. The activities of the entity primarily relate to securitizations,
leasing arrangements, or other forms of asset-backed financing.

*The term related parties as used in this list of
conditions refers to all parties identified in paragraph 16, except de facto
agents under item 16 (d)(i).

Deferral of effective date

In conjunction with the scope out and other revisions
to FIN 46 in FIN 46-R, the FASB agreed to Board Member Ed Trott’s proposal
to establish three buckets of firms--public entities, public small business
entities and non-public entities, with different deferrals.

As a result most firms will have roughly a quarter to
digest, implement and have audited their application of the revised, FIN 46-R.
Since for most SPE’s of old the changes in FIN 46-R are negligible, the FASB
sees this as a realistic proposition. [Leslie Seidman and George Batavick,
however, continue to hold dissenting views, suggesting that the FIN 46-R
changes are far from trivial and believe the effective date for SPEs should be
deferred as well. Ms. Seidman points to changes in guidance touching on
derivatives, service contracts and equity investment treatment that may take a
significant amount of time for constituents to digest. She is also concerned,
for example, that divergence in market practice for expected return/loss
calculations may cause different conclusions on VIE consolidation tests to be
reached across firms.]

Non-small business public entities will still have to
apply FIN 46, or early adopt FIN 46-R, for all SPEs created prior to February
1, 2003 at the end of the first interim or annual reporting period ending
after December 15, 2003. Unless the entity decides to early adopt FIN 46-R,
its provisions must be applied as of the end of the first interim or annual
reporting period ending after March 15, 2004. For all other VIEs that still
fall within the scope of FIN 46-R and were created prior to February 1, 2003,
non-small business public entities must adopt FIN 46-R at the end of the first
interim or annual reporting period ending after March 15, 2004 (they may also
elect to early adopt the revised guidance at year end). The same holds true
for all entities (SPEs of old or not) created after January 31, 2003 that were
required to be accounted for under FIN 46: FIN 46 will continue to apply,
unless they choose to early adopt FIN 46-R, until periods after March 15,
2004, when FIN 46-R applies to all entities.

Public small business entities will have until the
end of the first interim or annual period after December 15, 2004, an
additional year, to adopt FIN 46-R for SPEs created after January 31, 2003,
though they are free to early adopt. Like larger firms, however, they must
adopt pre-revision FIN 46 provisions for SPEs created prior to February 1,
2003, but they have until periods after December 15, 2004 to adjust for the
FIN 46-R change.

Deloitte and Touche provides a nice summary of FIN 46. The new interpretation
was prompted in large measure by the fraudulent use of offshore special purpose
entities (now called variable interest entities).

Those
FEI members whose companies have November 30 or December 31 fiscal year-ends
need to take a close look at FASB Interpretation No. 46, Consolidation of
Variable Interest Entities, as soon as possible for two reasons: (1) FIN 46
has disclosure requirements that become effective for financial statements
issued after January 31, 2003; (2) FIN 46 applies to all types of
unconsolidated entities (e.g., joint ventures, partnerships, cost basis
investments, etc.). For those who have not followed this project closely, FIN
46 could affect your company's financial statements even if it has no
involvement with so-called "special purpose entities" (SPEs). The
following is a brief synopsis of the rule. The complete document is available
now at the FASB's web site at: http://www.fasb.org/interp46.pdf.

Transactions that will come under
FIN 46 scrutiny include the following:

off-balance-sheet R&D ventures,

synthetic leases,

asset-backed commercial paper,

collateralized debt obligation, and

exploration ventures,

others.

A
summary of the new interpretation is as follows:

This
Interpretation of Accounting Research Bulletin No. 51, Consolidated Financial
Statements, addresses consolidation by business enterprises of variable
interest entities, * which have one or both of the following
characteristics:

1.
The equity investment at risk is not sufficient to permit the entity to
finance its activities without additional subordinated financial support
from other parties, which is provided through other interests that will
absorb some or all of the expected losses of the entity.

2.
The equity investors lack one or more of the following essential
characteristics of a controlling financial interest:

a.
The direct or indirect ability to make decisions about the entity’s
activities through voting rights or similar rights

b.
The obligation to absorb the expected losses of the entity if they occur,
which makes it possible for the entity to finance its activities

c.
The right to receive the expected residual returns of the entity if they
occur, which is the compensation for the risk of absorbing the expected
losses.

The
following are exceptions to the scope of this Interpretation:

1.
Not-for-profit organizations are not subject to this Interpretation unless
they are used by business enterprises in an attempt to circumvent the
provisions of this Interpretation.

2.
Employee benefit plans subject to specific accounting requirements in
existing FASB Statements are not subject to this Interpretation.

3.
Registered investment companies are not required to consolidate a variable
interest entity unless the variable interest entity is a registered
investment company.

4.
Transferors to qualifying special-purpose entities and “grandfathered”
qualifying special-purpose entities subject to the reporting requirements of
FASB Statement No. 140, Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities, do not consolidate those
entities.

5.
No other enterprise consolidates a qualifying special-purpose entity or a
“grandfa-thered” qualifying special-purpose entity unless the enterprise
has the unilateral ability to cause the entity to liquidate or to change the
entity in such a way that it no longer meets the requirements to be a
qualifying special-purpose entity or “grandfathered” qualifying
special-purpose entity.

6.
Separate accounts of life insurance enterprises as described in AICPA
Auditing and Accounting Guide, Life and Health Insurance Entities, are not
subject to this Interpretation.

Reason
for Issuing This Interpretation

Transactions
involving variable interest entities have become increasingly common, and the
relevant accounting literature is fragmented and incomplete. ARB 51 requires
that an enterprise’s consolidated financial statements include subsidiaries
in which the enterprise has a controlling financial interest. That requirement
usually has been applied to subsidiaries in which an enterprise has a majority
voting interest, but in many circumstances the enterprise’s consolidated
financial statements do not include variable interest entities with which it
has similar relationships. The voting interest approach is not effective in
identifying controlling financial interests in entities that are not
controllable through voting interests or in which the equity investors do not
bear the residual economic risks.

The
objective of this Interpretation is not to restrict the use of variable
interest entities but to improve financial reporting by enterprises involved
with variable interest entities. The Board believes that if a business
enterprise has a controlling financial interest in a variable interest entity,
the assets, liabilities, and results of the activities of the variable
interest entity should be included in consolidated financial statements with
those of the business enterprise.

Differences
between This Interpretation and Current Practice

Under
current practice, two enterprises generally have been included in consolidated
financial statements because one enterprise controls the other through voting
interests. This Interpretation explains how to identify variable interest
entities and how an enterprise assesses its interests in a variable interest
entity to decide whether to consolidate that entity. This Interpretation
requires existing unconsolidated variable interest entities to be consolidated
by their primary beneficiaries if the entities do not effectively disperse
risks among parties involved. Variable interest entities that effectively
disperse risks will not be consolidated unless a single party holds an
interest or combination of interests that effectively recombines risks that
were previously dispersed.

An
enterprise that consolidates a variable interest entity is the primary
beneficiary of the variable interest entity. The primary beneficiary of a
variable interest entity is the party that absorbs a majority of the entity’s
expected losses, receives a majority of its expected residual returns, or
both, as a result of holding variable interests, which are the ownership,
contractual, or other pecuniary interests in an entity. The ability to make
decisions is not a variable interest, but it is an indication that the
decision maker should carefully consider whether it holds sufficient variable
interests to be the primary beneficiary. An enterprise with a variable
interest in a variable interest entity must consider variable interests of
related parties and de facto agents as its own in determining whether it is
the primary beneficiary of the entity.

Assets,
liabilities, and noncontrolling interests of newly consolidated variable
interest entities generally will be initially measured at their fair values
except for assets and liabilities transferred to a variable interest entity by
its primary beneficiary, which will continue to be measured as if they had not
been transferred. If recognizing those assets, liabilities, and noncontrolling
interests at their fair values results in a loss to the consolidated
enterprise, that loss will be reported immediately as an extraordinary item.
If recognizing those assets, liabilities, and noncontrolling interests at
their fair values would result in a gain to the consolidated enterprise, that
amount will be allocated to reduce the amounts assigned to assets in the same
manner as if consolidation resulted from a business combination. However,
assets, liabilities, and noncontrolling interests of newly consolidated
variable interest entities that are under common control with the primary
beneficiary are measured at the amounts at which they are carried in the
consolidated financial statements of the enterprise that controls them (or
would be carried if the controlling entity prepared financial statements) at
the date the enterprise becomes the primary beneficiary. After initial
measurement, the assets, liabilities, and noncontrolling interests of a
consolidated variable interest entity will be accounted for as if the entity
were consolidated based on voting interests. In some circumstances, earnings
of the variable interest entity attributed to the primary beneficiary arise
from sources other than investments in equity of the entity.

An
enterprise that holds significant variable interests in a variable interest
entity but is not the primary beneficiary is required to disclose (1) the
nature, purpose, size, and activities of the variable interest entity, (2) its
exposure to loss as a result of the variable interest holder’s involvement
with the entity, and (3) the nature of its involvement with the entity and
date when the involvement began. The primary beneficiary of a variable
interest entity is required to disclose (a) the nature, purpose, size, and
activities of the variable interest entity, (b) the carrying amount and
classification of consolidated assets that are collateral for the variable
interest entity’s obligations, and (c) any lack of recourse by creditors (or
beneficial interest holders) of a consolidated variable interest entity to the
general credit of the primary beneficiary.

How
This Interpretation Will Improve Financial Reporting

This
Interpretation is intended to achieve more consistent application of
consolidation policies to variable interest entities and, thus, to improve
comparability between enterprises engaged in similar activities even if some
of those activities are conducted through variable interest entities.
Including the assets, liabilities, and results of activities of variable
interest entities in the consolidated financial statements of their primary
beneficiaries will provide more complete information about the resources,
obligations, risks, and opportunities of the consolidated enterprise.
Disclosures about variable interest entities in which an enterprise has a
significant variable interest but does not consolidate will help financial
statement users assess the enterprise’s risks.

How
the Conclusions in This Interpretation Relate to the Conceptual Framework

FASB
Concepts Statement No. 1, Objectives of Financial Reporting by Business
Enterprises, states that financial reporting should provide information that
is useful in making business and economic decisions. Including variable
interest entities in consolidated financial statements with the primary
beneficiary will help achieve that objective by providing information that
helps in assessing the amounts, timing, and uncertainty of prospective net
cash flows of the consolidated entity.

Completeness
is identified in FASB Concepts Statement No. 2, Qualitative Characteristics of
Accounting Information, as an essential element of representational
faithfulness and relevance. Thus, to faithfully represent the total assets
that an enterprise controls and liabilities for which an enterprise is
responsible, assets and liabilities of variable interest entities for which
the enterprise is the primary beneficiary must be included in the enterprise’s
consolidated financial statements.

FASB
Concepts Statement No. 6, Elements of Financial Statements, defines assets, in
part, as probable future economic benefits obtained or controlled by a
particular entity and defines liabilities, in part, as obligations of a
particular entity to make probable future sacrifices of economic benefits. The
relationship between a variable interest entity and its primary beneficiary
results in control by the primary beneficiary of future benefits from the
assets of the variable interest entity even though the primary beneficiary may
not have the direct ability to make decisions about the uses of the assets.
Because the liabilities of the variable interest entity will require
sacrificing consolidated assets, those liabilities are obligations of the
primary beneficiary even though the creditors of the variable interest entity
may have no recourse to the general credit of the primary beneficiary.

At its September 17, 2003 Board Meeting, the Board will consider:
Whether to provide a limited-scope exception for a reporting entity's interest
in a variable interest entity, or potential variable interest entity, when:

The variable interest entity or potential variable interest entity existed
as of the Interpretation's issuance and effective dates, and

The reporting entity, after making exhaustive efforts, is unable to obtain
information necessary to determine if the entity is a variable interest
entity or to determine whether the reporting entity is the primary
beneficiary of the variable interest entity.

The Board also will consider whether to direct the staff to issue a proposed
FASB Staff Position (FSP) to defer the effective date of Interpretation 46 until
the end of the first interim or annual period ending after December 15, 2003,
for an interest held by a public entity in a variable interest entity that (a)
was not previously considered to be a special-purpose entity and (b) has assets
that are predominately nonfinancial. Examples of the types of interest to be
considered by the Board are franchise arrangements, supplier arrangements, and
troubled debt restructurings.

FASB Statement 167: Consolidation of Variable Interest Entities

FASB
significantly revamped its consolidation standards for variable interest
entities when it released Statement No. 167 in June 2009. Those standards rework
existing rules under FIN 46R for when a company must include a VIE on its books
with a potentially huge impact on corporate balance sheets.

The criteria
for determining an entity's VIE status have shifted, based now more on a
company's "obligations" and "power" over an entity than on ownership percentage
or absorption of losses. Complicating matters further are new disclosure
requirements to explain consolidation decisions.

New standards
cover fiscal years after Nov. 15, 2009, so they affect financials published as
soon as March or April 2010. Advisors must prepare now for the standards, which
require reevaluation of existing entity relationships, regardless of whether
VIEs were previously consolidated.

How Will This Statement Change Current
Practice?
This Statement amends Interpretation 46(R) to require an enterprise to
perform an analysis to determine whether the enterprise’s variable interest
or interests give it a controlling financial interest in a variable interest
entity. This analysis identifies the primary beneficiary of a variable
interest entity as the enterprise that has both of the following
characteristics:

a. The power to direct the
activities of a variable interest entity that most significantly impact
the entity’s economic performance

b. The obligation to absorb losses
of the entity that could potentially be significant to the variable
interest entity or the right to receive benefits from the entity that
could potentially be significant to the variable interest entity.
Additionally, an enterprise is required to assess whether it has an
implicit financial responsibility to ensure that a variable interest
entity operates as designed when determining whether it has the power to
direct the activities of the variable interest entity that most
significantly impact the entity’s economic performance.

This Statement amends Interpretation
46(R) to require ongoing reassessments of whether an enterprise is the
primary beneficiary of a variable interest entity. Before this Statement,
Interpretation 46(R) required reconsideration of whether an enterprise is
the primary beneficiary of a variable interest entity only when specific
events occurred. This Statement amends Interpretation 46(R) to eliminate the
quantitative approach previously required for determining the primary
beneficiary of a variable interest entity, which was based on determining
which enterprise absorbs the majority of the entity’s expected losses,
receives a majority of the entity’s expected residual returns, or both.

This Statement amends certain guidance
in Interpretation 46(R) for determining whether an entity is a variable
interest entity. It is possible that application of this revised guidance
will change an enterprise’s assessment of which entities with which it is
involved are variable interest entities.

This Statement amends Interpretation
46(R) to add an additional reconsideration event for determining whether an
entity is a variable interest entity when any changes in facts and
circumstances occur such that the holders of the equity investment at risk,
as a group, lose the power from voting rights or similar rights of those
investments to direct the activities of the entity that most significantly
impact the entity’s economic performance.

Under Interpretation 46(R), a troubled
debt restructuring as defined in paragraph 2 of FASB Statement No. 15,
Accounting by Debtors and Creditors for Troubled Debt Restructurings,
was not an event that required reconsideration of whether an entity is a
variable interest entity and whether an enterprise is the primary
beneficiary of a variable interest entity. This Statement eliminates that
exception.

This Statement amends Interpretation
46(R) to require enhanced disclosures that will provide users of financial
statements with more transparent information about an enterprise’s
involvement in a variable interest entity. The enhanced disclosures are
required for any enterprise that holds a variable interest in a variable
interest entity. This

Statement nullifies FASB Staff
Position FAS 140-4 and FIN 46(R)-8, Disclosures by Public Entities
(Enterprises) about Transfers of Financial Assets and Interests in Variable
Interest Entities. However, the content of the enhanced disclosures
required by this Statement is generally consistent with that previously
required by the FSP.

How Will This Statement Improve
Financial Reporting?]This Statement amends Interpretation 46(R)
to replace the quantitative-based risks and rewards calculation for
determining which enterprise, if any, has a controlling financial interest
in a variable interest entity with an approach focused on identifying which
enterprise has the power to direct the activities of a variable interest
entity that most significantly impact the entity’s economic performance and
(1) the obligation to absorb losses of the entity or (2) the right to
receive benefits from the entity. An approach that is expected to be
primarily qualitative will be more effective for identifying which
enterprise has a controlling financial interest in a variable interest
entity.

This Statement requires an additional
reconsideration event when determining whether an entity is a variable
interest entity when any changes in facts and circumstances occur such that
the holders of the equity investment at risk, as a group, lose the power
from voting rights or similar rights of those investments to direct the
activities of the entity that most significantly impact the entity’s
economic performance. It also requires ongoing assessments of whether an
enterprise is the primary beneficiary of a variable interest entity. These
requirements will provide more relevant and timely information to users of
financial statements.

This Statement amends Interpretation
46(R) to require additional disclosures about an enterprise’s involvement in
variable interest entities, which will enhance the information provided to
users of financial statements.

What Is the Effect of This Statement
on Convergence with International Financial Reporting Standards?The International Accounting Standards
Board (IASB) has a project on its agenda to reconsider its consolidation
guidance. The IASB issued two related Exposure Drafts, Consolidation
and Derecognition, in December 2008 and March 2009, respectively. The
IASB project on consolidation is a broader reconsideration of all
consolidation guidance (not just the guidance for variable interest
entities).

Although this Statement was not
developed as part of a joint project with the IASB, the FASB and IASB
continue to work together to issue guidance that yields similar
consolidation and disclosure results for special-purpose entities. The
ultimate goal of both Boards is to provide timely, transparent information
about interests in specialp purpose entities. However, the timeline and
anticipated effective date of the IASB project is different from the
effective date of this Statement.

This Statement addresses the potential
impacts on the provisions and application of Interpretation 46(R) as a
result of the elimination of the qualifying special-purpose entity concept
in Statement 166. Ultimately, the two Boards will seek to issue a converged
standard that addresses consolidation of all entities.

I don't really have much more to help you. You should be aware that the FASB
postponed FIN 46 and put three new Proposed Staff Positions FIN 46a, FIN 46b,
and FIN 46c out for discussion. These are on the current first page of http://www.fasb.org/

Dr. Jensen, My name is Erin XXXXX an I am an
undergraduate Accounting student at The University of YYYYY. I have been doing
some research on Special Purpose Entities for an Accounting Thesis that I am
writing this semester and I came across your page titled "Bob Jensen's
Overview of Special Purpose Entities." I found some very helpful
information, but I was wondering if you had any links to information on the
current FASB exposure draft, "Qualifying Special-Purpose Entities and
Isolation of Transferred Assets." I am trying to decipher it, but it is
difficult for me to understand because I do not have a good background in
Finance and this is my first assignment involving reading actual FASB
statements. I have found the topic to be interesting although very complex,
but unfortunately I am far from an expert in this field and need some
clarification on some of the terms in the draft. I would greatly appreciate
any information you may have.

Thank you,
Erin

On December 24, 2003, the FASB published a
revision to Interpretation 46 as a Christmas present to clarify and expand on accounting guidance for
variable interest entities. The additional guidance is in response to comments
received from constituents. The complete revised Interpretation 46 is available
on the FASB's website --- http://www.fasb.org/fin46r.pdf

Summary

This Interpretation of
Accounting Research Bulletin No. 51, Consolidated Financial Statements,
which replaces FASB Interpretation No. 46, Consolidation of Variable Interest
Entities, addresses consolidation by business enterprises of variable
interest entities, which have one or more of the following characteristics:

The equity investment at risk is not
sufficient to permit the entity to finance its activities without additional
subordinated financial support provided by any parties, including the equity
holders.

The equity investors lack one or more of the
following essential characteristics of a controlling financial interest:
a. The direct or indirect ability to make decisions about
the entity's activities through voting rights or similar rights.
b. The obligation to absorb the expected losses of the
entity.
c. The right to receive the expected residual returns of
the entity.

The equity investors have voting rights that
are not proportionate to their economic interests, and the activities of the
entity involve or are conducted on behalf of an investor with a
disproportionately small voting interest.

The following are exceptions to the scope of the
Interpretation:

Not-for-profit organizations are not subject
to this Interpretation unless they are used by business enterprises in an
attempt to circumvent the provisions of this Interpretation.

Employee benefit plans subject to specific
accounting requirements in existing FASB Statements are not subject to this
Interpretation.

Registered investment companies are not
required to consolidate a variable interest entity unless the variable
interest entity is a registered investment company.

Transferors to qualifying special-purpose
entities and "grandfathered" qualifying special-purpose entities
subject to the reporting requirements of FASB Statement No. 140, Accounting
for Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities, do not consolidate those entities.

No other enterprise consolidates a qualifying
special-purpose entity or a "grandfathered" qualifying
special-purpose entity unless the enterprise has the unilateral ability to
cause the entity to liquidate or to change the entity in such a way that it
no longer meets the requirements to be a qualifying special-purpose entity
or "grandfathered" qualifying special-purpose entity.

Separate accounts of life insurance
enterprises as described in the AICPA Auditing and Accounting Guide, Life
and Health Insurance Entities, are not subject to this Interpretation.

An enterprise with an interest in a variable
interest entity or potential variable interest entity created before
December 31, 2003, is not required to apply this Interpretation to that
entity if the enterprise, after making an exhaustive effort, is unable to
obtain the necessary information.

An entity that is deemed to be a business (as
defined in this Interpretation) need not be evaluated to determine if it is
a variable interest entity unless one of the following conditions exists:
a. The reporting enterprise, its related parties, or both
participated significantly in the design or redesign of the entity, and the
entity is neither a joint venture nor a franchisee.
b. The entity is designed so that substantially all of its
activities either involve or are conducted on behalf of the reporting
enterprise and its related parties.
c. The reporting enterprise and its related parties
provide more than half of the total of the equity, subordinated debt, and
other forms of subordinated financial support to the entity based on an
analysis of the fair values of the interests in the entity.
d. The activities of the entity are primarily related to
securitizations, other forms of asset-backed financings, or single-lessee
leasing arrangements.

An enterprise is not required to consolidate
a governmental organization and is not required to consolidate a financing
entity established by a governmental organization unless the financing
entity (a) is not a governmental organization and (b) is used by the
business enterprise in a manner similar to a variable interest entity in an
effort to circumvent the provisions of this Interpretation.

Reason for Issuing This Interpretation

Transactions involving variable
interest entities have become increasingly common, and the relevant accounting
literature is fragmented and incomplete. ARB 51 requires that an
enterprise's consolidated financial statements include subsidiaries in which the
enterprise has a controlling financial interest. That requirement usually
has been applied to subsidiaries in which an enterprise has a majority voting
interest, but in many circumstances the enterprise's consolidated financial
statements do not include variable interest entities with which it has similar
relationships. The voting interest approach is not effective in
identifying controlling financial interests in entities that are not
controllable through voting interests or in which the equity investors do not
bear the residual economic risks.

The objective of this
Interpretation is not to restrict the use of variable interest entities but to
improve financial reporting by enterprises involved with variable interest
entities. The Board believes that if a business enterprise has a
controlling financial interest in a variable interest entity, the assets,
liabilities, and results of the activities of the variable interest entity
should be included in consolidated financial statements with those of the
business enterprise.

Differences between This Interpretation and
Current Practice

Under current practice, two
enterprises generally have been included in consolidated financial statements
because one enterprise controls the other through voting interests. This
Interpretation explains how to identify variable interest entities and how an
enterprise assesses its interests in a variable interest entity to decide
whether to consolidate that entity. This Interpretation requires existing
unconsolidated variable interest entities to be consolidated by their primary
beneficiaries if the entities do not effectively disperse risks among parties
involved. Variable interest entities that effectively disperse risks will
not be consolidated unless a single party holds an interest or combination of
interests that effectively recombines risks that were previously dispersed.

An enterprise that consolidates a
variable interest entity is the primary beneficiary of the variable interest
entity. The primary beneficiary of a variable interest entity is the party
that absorbs a majority of the entity's expected losses, receives a majority of
its expected residual returns, or both, as a result of holding variable
interests, which are the ownership, contractual, or other pecuniary interests in
an entity that change with changes in the fair value of the entity's net assets
excluding variable interests. An enterprise with a variable interest in a
variable interest entity must consider variable interests of related parties and
de facto agents as its own in determining whether it is the primary beneficiary
of the entity.

Assets, liabilities, and
noncontrolling interests of newly consolidated variable interest entities
generally will be initially measured at their fair values except for assets and
liabilities transferred to a variable interest entity by its primary
beneficiary, which will continue to be measured as if they had not been
transferred. However, assets, liabilities, and noncontrolling interests of
newly consolidated variable interest entities that are under common control with
the primary beneficiary are measured at the amounts at which they are carried in
the consolidated financial statements of the enterprise that controls them (or
would be carried if the controlling entity prepared financial statements) at the
date of the enterprise becomes the primary beneficiary. Goodwill is
recognized only if the variable interest entity is a business as defined in this
Interpretation. Otherwise, the reporting enterprise will report an
extraordinary loss for that amount. After initial measurement, the assets,
liabilities, and noncontrolling interests of a consolidated variable
interest entity will be accounted for as if the entity was consolidated based on
voting interests. In some circumstances, earnings of the variable interest
entity attributed to the primary beneficiary arise from sources other than
investments in equity of the entity.

An enterprise that holds
significant variable interests in a variable interest entity but is not the
primary beneficiary is required to disclose (1) the nature, purpose, size, and
activities of the variable interest entity, (2) its exposure to loss as a result
of the variable interest holder's involvement with the entity, and (3) the
nature of its involvement with the entity and date when the involvement
began. The primary beneficiary of a variable interest entity is required
to disclose (a) the nature, purpose, size, and activities of the variable
interest entity, (b) the carrying amount and classification of consolidated
assets that are collateral for the variable interest entity's obligations, and
(c) any lack of recourse by creditors (or beneficial interest holders) of a
consolidated variable interest entity to the general credit of the primary
beneficiary.

How This Interpretation Will Improve Financial
Reporting

This Interpretation is intended to
achieve more consistent application of consolidation policies to variable
interest entities and, thus, to improve comparability between enterprises
engaged in similar activities even if some of those activities are conducted
through variable interest entities. Including the assets, liabilities, and
results of activities of variable interest entities in the consolidated
financial statements of their primary beneficiaries will provide more complete
information about the resources, obligations, risks, and opportunities of the
consolidated enterprise. Disclosure about variable interest entities in
which an enterprise has a significant variable interest but does not consolidate
will help financial statement users assess the enterprise's risk.

In June 2003, the
American Accounting Association's Financial Accounting Standards Committee
issued the following:

The
June 28, 2002 Financial Accounting Standards Board Exposure Draft (ED),
Proposed Interpretation: Consolidation of Certain Special-Purpose
Entities—an interpretation of ARB No. 51, addresses the consolidation of
special-purpose entities (SPEs). Accounting Research Bulletin (ARB) No. 51 (AICPA
1959), Consolidated Financial Statements, does not apply to SPEs because they
have no voting interests nor are they subject to control by means other than
voting shares. This Accounting Horizons commentary presents the views
of the American Accounting Association’s Financial Accounting Standards
Committee (hereafter, the Committee) with respect to the ED. An excerpt
is shown below.

Application of a
Principles-Based Consolidation Standard to SPEs

To illustrate the
application of a principles-based consolidation standard to a situation
contemplated by the ED, consider the case of a synthetic lease. A
company sets up an SPE to purchase and finance assets on its behalf, and the
assets are then leased to the company via an operating lease. The
company-lessee typically does not have an equity position in the SPE, but
effectively bears the risk and benefits of ownership of the leased assets
through residual value guarantees. Moreover, the company's use of the
assets and the residual value guarantees provide direct evidence of the
company's effective economic control over the SPE. Accordingly, the
company should consolidate the SPE under the Committee's approach to
consolidation.

Another example
involves a bank that creates an SPE to purchase receivables or debt
instruments such as car loans or lease payments in the marketplace. The
assets are not top grade and require active management. The SPE funds
its purchases by issuing various tranches of debt and 10 percent equity.
As the asset manager, the bank receives a "market-based" fee and can
be terminated after one year and annually thereafter by a majority vote of the
debt holders. The bank also provides a liquidity backstop that protects
the debt holders against delayed payments, up to some limit. The
backstop does not protect the equity holders.

In this example, the
bank does not control the assets; it is merely acting as an asset manager for
the benefit of other stakeholders in the structure. The presence of the
guarantee, while exposing the bank to some risk, is no different than the
types of guarantees that banks issue to other companies. Thus, the
Committee believes that the bank does not retain effective economic control
over the SPE. That is, it has not retained the risks and benefits of
ownership, and should not consolidate the SPE. Here, the objective
should be to provide high-quality disclosure about the risks accepted by the
bank. (See, for example, the Committee's letter to the FASB on the
Exposure Draft, Guarantor's Accounting and Disclosure Requirements,
Including Indirect Guarantees of Indebtedness of Others, available at http://www.aaa-edu.org,
or the related article published in Accounting Horizons [AAA FASC
2003a]).

HOW
DOES THE ED COMPARE WITH OUR PERSPECTIVE ON A
PRINCIPLES-BASED CONSOLIDATION STANDARD?

This
section outlines specific strengths and weaknesses of the ED relative to the
Committee's view on a principles-based consolidation standard.

Strengths

The
Committee believes that the ED moves accounting for SPEs from a rules-based
standard toward a principles-based standard. This is consistent with our
preferred approach for a general consolidation standard and with our July 2002
letter commenting on conceptual standards, available at http://www.aaa-edu.org,
or the related article published in Accounting Horizons (AAA FASC
2003b). If approved, the ED would likely result in more SPEs being
consolidated by the entities that have effective control over their
operations, consistent with our general approach to consolidation. The
Committee favors moving the basis for consolidation from an emphasis on legal
control to a notion of effective economic control, based on the concepts of
variable interests and primary beneficiary. This move toward an economic
definition of control should improve financial reporting by enhancing the
representational faithfulness of financial statements in those circumstances
where the risks and benefits of ownership are retained.

Weaknesses

The
Committee believes the ED has five potential weaknesses, which we discuss in
turn:

its
limitation to specific transactions and its scope exceptions,

a
lack of clarity in the variable interests constructs,

the
inclusion of a bright-line rule for defining sufficient equity investment,

COMMENTARY
"The Evolving Accounting Standards for Special Purpose Entities and Consolidations,"by Al L. Hartgraves and George J. Benston, Accounting
Horizons, September 2002, pp. 245-258.
The following are only selected excerpts.

This paper reviews the major actions taken by the
accounting standard setters--the Financial Accounting Standards Board (FASB) and
its Emerging Issues Task Force (EITF)--in connection with special purpose
entities (SPEs) and traces the evolution of related authoritative
guidance. Accounting for SPEs entered public and professional prominence
as a result of the Enron Corporation's failure. The primary accounting
issues regarding these entities are (1) whether they should be consolidated into
the sponsor's1 (or primary beneficiary's) financial statements
or left "off-balance sheet," and (2) whether the sponsor should be
able to treat gains and losses resulting from transactions with SPEs as
independent, arm's-length transactions. Critics harshly criticized Enron's
auditor, Arthur Andersen, for allowing Enron to exclude from its financial
statements the SPEs it sponsored, thereby keeping a substantial amount of debt
off its balance sheet and recognizing substantially higher profits from
transactions with SPEs. We believe it is useful, therefore, to review both
the authoritative guidance for the general area of consolidation of financial
statements as well as guidance specific to SPEs. This review also provides
insight into how standard setting leading to changes in GAAP responds to changes
in business practice, and how it might have been more effective in helping to
prevent abuses in accounting for SPEs, such as those that ostensibly led to or
exacerbated the downfall of Enron (Powers et al. 2002).

1The
term "sponsor" is sometimes used to refer to the organization that
legally creates the SPE, which may or may not be the primary beneficiary of the
SPE. At other times, and in this paper, it is used to refer to the company
for whose primary benefit the SPE has been created.

WHAT ARE SPECIAL PURPOSE ENTITIES?

Until recently, many people in the accounting profession,
including accounting educators, never heard of SPEs. Some who heard of
these esoteric financing vehicles knew little about how they operated or the
accounting standards that guide the accounting and financial reporting by
companies who sponsor SPEs. Reports in the popular press that preceded
Enron's Chapter 11 filing in December 2001 introduced many accountants for the
first time to the topic of SPEs and sent many CPAs scrambling to understand the
generally accepted accounting principles (GAAP) dealing with these
entities. Even though SPE financing vehicles have been around for about
two decades, they failed to capture the attention of many participants in the
mainstream of accounting discourse. A search for references to SPEs in
financial accounting textbooks yields virtually no results, and a search of the
academic and professional accounting literature provides, at best, a limited
explanation of this area of accounting.

Also called special purpose vehicles, SPEs typically
are defined as entities created for a limited purpose, with a limited life and
limited activities, and designed to benefit a single company. They may
take the legal form of a partnership, corporation, trust, or joint
venture. SPEs began appearing in the portfolio of financing vehicles that
investment banks and financial institutions offered their business customers in
the late 1970s to early 1980s, primarily to help banks and other companies
monetize, through off-balance-sheet securitizations, the substantial amounts of
consumer receivables on their balance sheets. A newly created SPE would
acquire capital by issuing equity and debt securities, and use the proceeds to
purchase receivables from the sponsoring company, which often guaranteed the
debt issued by the SPE. Because the receivables have limited and reliably
measured risk of nonrepayment, a relatively small amount of equity usually was
sufficient to absorb all expected losses, thus making it unlikely that the
sponsoring company would have to fulfill its guarantee. In this way the
sponsoring company could convert receivables into cash while paying a lower rate
of interest than the alternative of debt or factoring, as the debt holder could
be repaid from the collection of the receivables or the sponsor. SPEs also
allow the sponsors to remove receivables from their balance sheets, and avoid
recognizing debt incurred in the securitization.

Other Uses of SPEs

Another major application in the early years of SPEs related
to transactions involving the acquisition of plant and equipment under long-term
lease contracts. Companies could sponsor an SPE to acquire long-term
assets with newly acquired debt and/or equity and enter into a contract to lease
the assets from the SPE. This often enabled companies to treat the
contract as an operating lease for accounting purposes, thereby placing the
asset and related debt on the SPE's balance sheet instead of that of the
sponsoring company.

Other SPEs, typically organized as limited partnerships, also
have been employed for more than 20 years to fund research and development
(R&D) activities. The sponsor often has only a contractual interest in
the SPE, not an equity interest. The crucial accounting issue for these
SPEs, addressed in FASB Statement No. 68 (FASB 1982), is whether the sponsor has
directly or indirectly agreed to repay the funds provided by the outside
parties. If such an obligation exists, then the sponsor recognizes it as a
liability, and the sponsor records the R&D costs incurred by the SPE as an
expense. To avoid recognizing the liability and expense, the sponsor must
demonstrate that the financial risks involved with the R&D activities are
transferred from the sponsor to the outside parties.

SPE's and Off-Balance-Sheet Financing

Before discussing the evolution of authoritative guidance for
SPEs, we examine the broader issue of off-balance-sheet financing, the context
within which the guidance has been developed. SPEs are just one of the
vehicles that companies use to structure financing that avoids recognizing
assets and liabilities on their financial statements. Other vehicles
include operating leases, take-or-pay contracts, and throughput arrangements2
that enable a company to use something in its future operations in exchange for
agreed upon payments. In these situations the accounting problem is to
determine whether an asset or liability exists, and when to report such items on
the balance sheet. GAAP already requires arrangements such as capital
leases and certain SPEs to be included on the balance sheet of the primary
beneficiary of the contracts. For some specified arrangements where assets
and liabilities are not reported on the balance sheet, particularly operating
leases, information about future obligations under the contracts must be
disclosed in the notes to the financial statements.

Consider unconsolidated equity investments in which an
investor owns less than 50 percent, SPEs created for the primary benefit of a
company, or other off-balance-sheet entities. Here the challenge to the
accounting profession is to focus on whether consolidation of such entities
actually improves users' understanding of a company's financial position and
results of operations. For most equity method investments, consolidation
does not change net income or net assets, causing only offsetting changes in the
components of those measures. Consolidating equity method investments
currently not consolidated could reduce disclosures about those investments in
the notes to the financial statements. As a broad objective, the FASB and
the SEC should guide the profession in requiring on-balance-sheet treatment
where it enhances the financial statements, but allowing off-balance-sheet
treatment where it provides better information to investors.

2 Typical
take-or-pay contracts obligate the purchaser to take and pay for any
product that is offered to it or pay a specified amount if it refuses to take
the product. A throughput arrangement involves an agreement to put
a specified amount of product per period through a particular facility; for
example, an agreement to ship a specified amount of crude oil per period through
a particular pipeline (New York Times 2002).

Sources of Authoritative Guidance for Accounting for SPEs

When the idea of SPEs was first conceived in the minds of some
bright financial engineers, no definitive accounting guidance existed.
Although specific accounting guidance for innovative business methods of
necessity must lag actual practice, the conceptual framework and other general
guidelines should help accountants treat innovative practices. When SPEs
began to appear, corporate accountants, auditors, and the SEC could look only to
general principles in the authoritative accounting literature regarding the
recognition and de-recognition of assets and liabilities, criteria for
recognizing asset sales, consolidation of related entities, and more generally
to the "entity concept" literature.

From the early 1980s until the mid-1990s, SPEs proliferated in
business practice without any specific official guidance from the Financial
Accounting Standards Board (FASB). Until 1996, all specific guidance
regarding SPEs came from the FASB's surrogate body, the Emerging Issues Task
Force (EITF), formed by the FASB in 1984 to provide timely financial-reporting
guidance on matters that the Board may not have addressed or issued
authoritative guidance. As stated on the FASB's web site (FASB 2002a), the
composition of the EITF is designed to include persons in a position to be aware
of emerging issues before they become widespread and before divergent practices
regarding them become entrenched. Therefore, when the EITF reaches a
consensus on an issue, signified by the support of 11 of the 13 voting members,
the FASB usually takes that as an indication that no Board action is
needed. Consensus positions of the EITF are considered part of GAAP.
However, lack of consensus is often viewed as an indication that action by the
FASB is necessary.

Nine of the 13 voting members of the EITF are affiliated with
public accounting firms, with one member from each of the Big 5 firms, and four
members from large companies.3 The Chief Accountant of
the Securities and Exchange Commission attends EITF meetings regularly as an
observer with the right to participate in discussions and present the
SEC's views on topics of discussion. Although the
FASB's Director of Research and Technical Activities is the non-voting Chairman
of the EITF, there is no overlap between the members of the FASB and the EITF.
Note that the influence of the public accounting sector of the accounting
profession is much greater on the EITF (nine of 13 members are currently public
accounting practitioners) than it is on the FASB (three of seven full-time
members were public accounting practitioners prior to joining the Board).
One might conclude that authoritative guidance provided by the EITF is likely to
have more of a public accounting tilt than if it is provided by the FASB.

The first FASB statement that included any direct reference to
SPE's was Statement No. 125 (FASB 1996), later replaced by Statement No. 140 (FASB
2000b). Both of these Statements focus narrowly on issues involving the
transfer (sale) of financial assets, primarily securitization and servicing of
receivables. Authoritative guidance for other SPEs has been developed in a
rather piecemeal fashion by the EITF. Exhibit 1 lists in chronological
order the major FASB and EITF pronouncements addressing consolidations and SPEs.
The next section of the paper discusses this authoritative guidance.

AUTHORITATIVE GUIDANCE ON CONSOLIDATIONS

Accounting Research Bulletin No. 51

Over the past 40 to 50 years, the accounting
profession gradually developed general policies governing the consolidation of
financial statements of companies and their controlled subsidiaries and
affiliates. Accounting Research Bulletin (ARB) No. 51 (AICPA 1959)
established broad requirements for companies to fully consolidate majority-owned
subsidiaries into their financial statements and show the equity of
minority-interest shareholders in the consolidated financial statements.
ARB No. 51 also requires the elimination of intercompany balances and
transactions between the two entities so that the consolidated statements
represent the financial position and results of operations of a single reporting
entity. An important exception in ARB No. 51 that allowed companies to
avoid consolidation for "nonhomogeneous" majority-owned subsidiaries
was removed in 1987.

EXHIBIT 1
Chronology of Major Accounting Pronouncements
Related to Consolidations and SPEs

After more than 20 years since SPEs appeared on
the business scene, there remains a confusing, if not convoluted, set of
guidelines regarding the consolidation of SPEs. Two streams of reasonably
understandable guidance exist for leasing transactions (EITF Issue No. 90-15)
and for transfers of financial assets through securitizations (FASB Statement
No. 140). Until now, the only authoritative guidance for other types of
SPEs, including many of those used by Enron, is the indication by the EITF and
SEC that the guidance outlined in EITF Issue No. 90-15 and Topic D-14, which
deals specifically with leasing transactions, is "appropriate" for
other non-lease-related SPEs.

The bankruptcy of the Enron Corporation
associated with its use of sponsored un-consolidated SPEs has brought these
financial innovations to the attention of the public and accounting
profession. From our review of the slowly evolving authoritative guidance
on the proper GAAP accounting for SPEs, we draw the following conclusions.
Initially, although thinly capitalizated, SPEs designed to monetize assets such
as accounts receivable were properly accounted for by applying the traditional
definitions of assets, liabilities, and unrelated entities. These SPEs
engage in FASB Statement No. 140-type transactions. Cash is usually
received for the receivables sold to the SPEs, so there is no problem with
establishing the value and, hence, the gain or loss on the assets sold.
Although the sponsoring corporation often guarantees the SPEs' debt, the
probability of this becoming a liability is small, because the equity capital
provided by unrelated investors is sufficient to absorb the losses, which could
be measured objectively. Nonconsolidation is generally appropriate.

Then, SPEs were used for the acquisition or sale
and leaseback of plant and equipment. However, the arrangements companies
must make with their lessor SPEs to avoid consolidation under EITF Issue No.
90-15 are not substantially different from arrangements typically made when
leasing properties from established financial institutions in terms of the risks
assumed by the lessee. The problem at Enron, as it expanded the role of
SPEs, was that even though its SPEs were thinly capitalized and held assets that
posed considerable risks, Enron took the limited authoritative pronouncements
literally, allowing them to not consolidate the SPEs, even in situations where
Enron assumed virtually all of the risks. See Benston and Hartgraves
(2002) for a description and analysis of what Enron did and did not do.

Amerco Inc., the parent company of U-Haul International, itself hauled Big
Four accounting firm PricewaterhouseCoopers into federal court in Arizona last
week charging that the Big Four accounting firm was to blame for Amerco's dire
financial situation. http://www.accountingweb.com/item/97460

Amerco
Inc., the parent of U-Haul International, said yesterday that it had sued its
former auditor PricewaterhouseCoopers for more than $2.5 billion in damages.

In the suit, Amerco accused PricewaterhouseCoopers of
providing financial advice that it said was flawed and led it to the brink of
bankruptcy.

The suit, filed on Friday in the
Federal District Court
for
Arizona
, contends PricewaterhouseCoopers's advice, coupled with delays in disclosing
an error once it was discovered, caused events that put Amerco in
"serious jeopardy."

Amerco said the delay forced it to postpone filing
financial statements with regulators and put it in danger of being delisted
from the Nasdaq stock market. Amerco, which named a new finance chief last
week, avoided bankruptcy by reaching an agreement with lenders last month.

"They gave us bad advice for seven straight
years," Amerco's general counsel, Gary Klinefelter, said in an interview
yesterday. "We're in the business of renting out trucks and trailers, and
they're in the business of giving out accounting advice."

A spokesman for PricewaterhouseCoopers, David Nestor,
said the lawsuit appeared to be an effort by Amerco's management to shift
blame away from itself.

"The primary responsibility for the accuracy of
financial statements lies with the company," Mr. Nestor said. "Once
it became apparent that there was an error in Amerco's, we worked with them to
get their financial statements correct, which is, of course, the important
thing."

The dispute centers on financing arrangements known
as special purpose entities that Amerco set up in the mid-1990's. These were
created to help expand the company's self-storage business without weighing
down its balance sheet with debt.

Mr. Klinefelter said the idea for the special purpose
entities, a term that has gained notoriety since they played a crucial role in
Enron's
collapse, came from PricewaterhouseCoopers, which guided the deals.

Amerco said in the lawsuit that
it had been assured by PricewaterhouseCoopers that the special purpose
entities could be excluded from its financial statements under federal
accounting rules. But last year, after the Enron debacle put the spotlight on
these arrangements, PricewaterhouseCoopers re-examined the accounting and
realized that Amerco's financial statements had to be restated to include
those entities, Amerco said.

"ENRON: what happened and what we can learn
from it," by George J. Benston
and Al L. Hartgraves, Journal of Accounting and Public Policy, 2002, pp.
125-127
The following are excerpts only.

Abstract

Enron's accounting for its non-consolidated special-purpose
entities (SPEs), sales of its own stock and other assets to the SPEs, and
mark-ups of investments to fair value substantially inflated its reported
revenue, net income, and stockholders' equity, and possibly understated its
liabilities. We delineate six accounting and auditing issues, for which we
describe, analyze, and indicate the effect on Enron's financial statements of
their complicated structures and transactions. We next consider the role
of Enron's board of directors, audit committee, and outside attorneys and
auditors. From the foregoing, we evaluate the extent to which Enron and
Andersen followed the requirements of GAAP and GAAS, from which we draw lessons
and conclusions.

The accounting issues

The transactions involving SPEs at Enron, and the related
accounting issues are, indeed, very complex. This section summarizes some
of the key transactions and their related accounting effects. The Powers
Report, a 218-page document, provides in great detail a discussion of a selected
group of Enron SPEs that have been the central focus of the Enron
investigations. While very much less detailed than the Powers Report, the
discussion in the following section (which may seem laborious at times),
supplemented with additional material that became available after publication of
the Report, should provide the reader with insight into how Enron sought to bend
the accounting rules to their advantage. However, even a cursory review of
this section will give the reader a sense of the complex financing structures
that Enron used in an attempt to create various financing, tax, and accounting
advantages.

Six accounting and auditing issues are of primary importance,
since they were used extensively by Enron to manipulate its reported figures:
(1) The accounting policy of not consolidating SPEs that appear to have
permitted Enron to hide losses and debt from investors. (2) The accounting
treatment of sales of Enron's merchant investments to unconsolidated (though
actually controlled) SPEs as if these were arm's length transactions. (3)
Enron's income recognition practice of recording as current income fees for
services rendered in future periods and recording revenue from sales of forward
contracts, which were, in effect, disguised loans. (4) Fair-value
accounting resulting in restatements of merchant investments that were not based
on trustworthy numbers. (5) Enron's accounting for its stock that was
issued to and held by SPEs. (6) Inadequate disclosure of related party
transactions and conflicts of interest, and their costs to stockholders.

By November 2000, Enron had entered into derivative contracts
with the Raptors I, II, and III with a notional value of $1.5 billion on which
it had a gain of $500 million. However, the Raptors' principal asset from
which it could pay this amount consisted of Enron stock or obligations, or TNPC
stock. By late March 2001, as the price of Enron's shares declined, the
Raptors' credit capacity also declined. To avoid having to report a $500
million pre-tax charge against earnings, Enron executed a
cross-collateralization among the Raptors, "invested" additional Enron
stock contracts, and engaged in a series of complex and questionable hedges and
swaps with the Raptors. Based on these moves (which Andersen apparently
approved), it was determined that a loss of only $36.6 million had to be
recorded for the first quarter of 2001.

In September 2001 Enron terminated the Raptors by buying out
LJM2 for approximately $35 million, even though they estimated that their
combined assets were approximately $2.5 billion and combined liabilities $3.2
billion. This resulted in a charge of approximately $710 million after
taxes on Enron's third quarter 2001 financial statements. In all, Enron's
not consolidating these SPEs increased its reported earnings as follows
($millions):

Thus, at a very considerable cost to shareholders,
Enron's managers temporarily were able to hide substantial loses.

Summary and conclusions

We believe that US GAAP, as structured and administered by the
SEC, the FASB, and the AICPA, are substantially responsible for the Enron
accounting debacle. Enron and its outside counsel and auditor felt
comfortable in following the specified accounting requirements for consolidation
of SPEs. The SEC had the responsibility and opportunity to change these
rules to reflect the known fact that corporations were using this vehicle to
keep liabilities off their balance sheets, although the sponsoring corporations
were substantially (often almost entirely) liable for the SPEs' obligations.

We also believe that the UK GAAP, which requires auditors to
report a "true and fair view" of an enterprises' financial condition
is preferable to the highly specified US model. The US model allows--even
encourages--corporate officers to view accounting requirements as if they were
specified in a tax code. For taxes, avoidance of a tax liability by any
legally permissible means not only is acceptable, but is an obligation of
corporations acting in the interests of their shareholders. Enron appears
to have taken the same approach to accounting (except that what was done was
detrimental to its shareholders). The gatekeepers (Vinson & Elkins and
Andersen) seem to have gone along and possibly even participated in this
approach to accounting.

The most important lesson with respect to GAAS is that
Andersen's partners and staff do not appear to have exercised the requisite
skepticism that auditors should adopt. Rather, they appear to have
accepted too readily management's valuations and determinations with respect to
valuations and related-party transactions. It is possible that this
presumed lack of skepticism and distance is simply a failing of the particular
auditors-in-charge. Or, it may be a consequence of auditors having been
associated with Enron for many years. (Familiarity may breed
over-involvement with and empathy for managements' worldview, rather than
contempt.) Or, the auditors in charge of the Enron audit may have
overlooked or supported their client's overly "aggressive" accounting,
misleading, and possibly fraudulent accounting practices in order to protect
their very salaries and bonuses.13 Or, as many critics have charged, the
gatekeepers may have been corrupted by the sizeable audit and possibly the
non-audit fees paid by Enron.

Andersen's audit personnel also might have been incapable of
understanding the complex financial entities and instruments structured by
Enron's chief financial officer, Andrew Fastow. These auditors dealt with
Enron when it was an oil and gas producer and distributor. In recent
years, it became primarily a dealer in financial instruments and a developer of
new ventures. For reasons that have yet to be explained, Andersen did not
replace these auditors or (apparently) provide them with the requisite
expertise. Another lesson, then, is that CPA firms should ascertain that
their personnel are capable of dealing with the presently existing activities of
their clients.

Synthetic Lease
= a financing structured to be treated as a lease for accounting purposes
and a loan for tax purposes. The structure is used by corporations that are
seeking OBSF reporting of their asset based financing, and that can
efficiently use the tax benefits of owning the financed asset.

Synthetic
Lease Structure (Sponsors Sell the Asset to the SPE and Then Lease It
Back)

A common
approach is for the sponsor to sell the asset to the SPE and then
lease it back from the SPE via what is known as synthetic leasing.
A synthetic lease is structured under FAS 140 rules such that a
sale/leaseback transaction takes place where the fair value of the
assets "sold" can be reported by the sponsor as "revenue" for
financial reporting. In a synthetic lease, this "revenue" does not
have to be reported up-front for tax purposes even though it is
reported up-front for financial reporting purposes.

Proceeds from
the sale to an SPE in this instance are generally long-term
receivables rather than cash (which is the primary reason the sale
revenues are not taxed up-front).

The synthetic
leaseback terms are generally such that the sponsor does not have to
book the leased asset or the lease liability under FAS 13 as a
capital lease (i.e., some clause in the lease contract allows the
asset to be kept off balance sheet as an operating lease). Hence
the financing of the lease asset remains off balance sheet. This is
one ploy used by airlines and oil companies to keep assets and
"debt" off the balance sheet as well as deferring taxes.

If the SPE
actually manages the transferred assets (e.g., a pipeline or a
refinery), then throughput or take-or-pay contracts may take the
place of leasing.

Jensen Comment
The history of some accounting standards is that they are not neutral in the
economy. Exhibit A is FAS 123R that virtually ended employee stock options
as a means of compensation. Exhibit B is comprised of FAS 141, 142, and 147
that virtually ended the synthetic leasing industry ---
http://en.wikipedia.org/wiki/Synthetic_lease

In
June 2003, the American Accounting Association's Financial Accounting
Standards Committee issued the following:

The
June 28, 2002 Financial Accounting Standards Board Exposure Draft (ED),
Proposed Interpretation: Consolidation of Certain Special-Purpose
Entities—an interpretation of ARB No. 51, addresses the consolidation of
special-purpose entities (SPEs). Accounting Research Bulletin (ARB) No. 51 (AICPA
1959), Consolidated Financial Statements, does not apply to SPEs because
they have no voting interests nor are they subject to control by means other
than voting shares. This Accounting Horizons commentary presents the
views of the American Accounting Association’s Financial Accounting
Standards Committee (hereafter, the Committee) with respect to the ED. An
excerpt is shown below.

Application of a
Principles-Based Consolidation Standard to SPEs

To
illustrate the application of a principles-based consolidation standard
to a situation contemplated by the ED, consider the case of a synthetic
lease. A company sets up an SPE to purchase and finance assets on its
behalf, and the assets are then leased to the company via an operating
lease. The company-lessee typically does not have an equity position in
the SPE, but effectively bears the risk and benefits of ownership of the
leased assets through residual value guarantees. Moreover, the
company's use of the assets and the residual value guarantees provide
direct evidence of the company's effective economic control over the SPE.
Accordingly, the company should consolidate the SPE under the
Committee's approach to consolidation.

Another example involves a bank that creates an SPE to purchase
receivables or debt instruments such as car loans or lease payments in
the marketplace. The assets are not top grade and require active
management. The SPE funds its purchases by issuing various tranches of
debt and 10 percent equity. As the asset manager, the bank receives a
"market-based" fee and can be terminated after one year and annually
thereafter by a majority vote of the debt holders. The bank also
provides a liquidity backstop that protects the debt holders against
delayed payments, up to some limit. The backstop does not protect the
equity holders.

In
this example, the bank does not control the assets; it is merely acting
as an asset manager for the benefit of other stakeholders in the
structure. The presence of the guarantee, while exposing the bank to
some risk, is no different than the types of guarantees that banks issue
to other companies. Thus, the Committee believes that the bank does not
retain effective economic control over the SPE. That is, it has not
retained the risks and benefits of ownership, and should not consolidate
the SPE. Here, the objective should be to provide high-quality
disclosure about the risks accepted by the bank. (See, for example, the
Committee's letter to the FASB on the Exposure Draft, Guarantor's
Accounting and Disclosure Requirements, Including Indirect Guarantees of
Indebtedness of Others, available at
http://www.aaa-edu.org, or the
related article published in Accounting Horizons [AAA FASC
2003a]).

HOW DOES THE ED
COMPARE WITH OUR PERSPECTIVE ON A
PRINCIPLES-BASED CONSOLIDATION STANDARD?

This section outlines specific strengths and weaknesses of the ED
relative to the Committee's view on a principles-based consolidation
standard.

Strengths

The Committee believes that the ED moves accounting for SPEs from a
rules-based standard toward a principles-based standard. This is
consistent with our preferred approach for a general consolidation
standard and with our July 2002 letter commenting on conceptual
standards, available at
http://www.aaa-edu.org, or the related article published in
Accounting Horizons (AAA FASC 2003b). If approved, the ED would
likely result in more SPEs being consolidated by the entities that have
effective control over their operations, consistent with our general
approach to consolidation. The Committee favors moving the basis for
consolidation from an emphasis on legal control to a notion of effective
economic control, based on the concepts of variable interests and
primary beneficiary. This move toward an economic definition of control
should improve financial reporting by enhancing the representational
faithfulness of financial statements in those circumstances where the
risks and benefits of ownership are retained.

Weaknesses

The Committee believes the ED has five potential weaknesses, which we
discuss in turn:

its limitation
to specific transactions and its scope exceptions,

a lack of
clarity in the variable interests constructs,

the inclusion
of a bright-line rule for defining sufficient equity investment,

the limited
implementation guidance, and

the absence of
enhanced disclosure requirements.

From The Wall Street Journal's Accounting
Educators' Reviews on February February 22, 2002

SUMMARY: The article includes a discussion of the
features of synthetic leases and the reasons that they are attractive alternatives to
purchases and normal lease agreements.

QUESTIONS:
1.) List the properties of synthetic leases. How are synthetic leases different from
"normal" lease agreements? How are synthetic leases different from purchasing
assets?

2.) Are synthetic leases accounted for as capital
leases or operating leases? Support your answer. In what situations is a lease transaction
accounted for as a capital lease? How are the financial statements different if a
transaction is accounted for as a capital lease versus an operating lease? In substance,
does it appear that a synthetic lease is more similar to a purchase or an operating lease?
Support your answer.

3.) What is meant by DuGan when he said,
"but synthetic leases have a hidden balloon payment."? Should a balloon payment
be recorded on the financial statements? Support your answer.

4.) Should companies be prohibited or discouraged
from engaging in synthetic leases? Support your answer. Is better disclosure of synthetic
lease transactions needed in financial reporting? What changes in financial reporting are
needed to provide better disclosure of synthetic lease transactions?

The widespread use of so-called
synthetic leases by companies to purchase and build everything from new campuses to retail
stores is coming under increased scrutiny. But that's not stopping a handful of firms from
plowing ahead with the controversial financing method.

A synthetic-lease arrangement
allows a company to get the tax benefits associated with owning real estate, while keeping
the debt associated with it off its balance sheet. Critics say that such leases are an
accounting maneuver that hides potential liabilities and can be used to boost earnings per
share.

AOL Time Warner Inc., for one,
remains committed to financing the construction of its new Manhattan headquarters at the
site of the old New York Coliseum and a new production facility in Atlanta with a $1
billion synthetic lease with Bank of America Corp., according to Michael Colacino of
real-estate services firm Julien J. Studley Inc., who worked on the deal for the media
giant.

Enron Corp.'s use of off-balance
sheet subsidiaries were allegedly used "to conceal lots and lots of debt" and
"misdirect people away from understanding" its core business, says Mr. Colacino.
In contrast, synthetic leases are "used to finance real estate and equipment that
aren't part of the core business of a company." For AOL Time Warner, the synthetic
lease is "not a material issue."

A spokeswoman for AOL says a
synthetic lease "continues to provide a diversified source of tax advantaged,
cost-efficient financing ... our synthetic leases are disclosed in our financial
statements, and we believe they are in the best interest of our shareholders."

Cheaper Alternative

In a synthetic-lease deal, a
financial institution typically sets up a special-purpose entity that essentially borrows
money from the institution to build a facility or purchase an existing one for a company.
The special-purpose entity holds the title to the property and leases the property to the
respective company. In many cases, the company gets a lower interest rate, which is a
floating rate based on the firm's creditworthiness rather than on the value of the real
estate, although there are up-front legal and accounting costs. Companies have used
synthetic leases to finance equipment purchases as well.

They see them as a cheaper
alternative to leasing, purchasing or developing property with traditional loans. For
accounting purposes, a company is considered a tenant leasing the property under a
synthetic-lease structure. As such, the transaction is treated like a simple operating
lease, and the company doesn't have to carry the asset on its balance sheet -- though many
companies mention their use in a footnote. That means the company avoids taking
depreciation charges against earnings. For tax purposes, the company is considered the
owner of the asset. As such, it is entitled to deduct the interest payments and the
depreciation of the value of the property.

What's more, typically these
lease deals run from three to seven years with options to renew. And that's where
potential problems can arise.

Because the leases are
short-term, if a company can't renew a synthetic lease because its credit rating has
fallen, it may all of a sudden be faced with getting new financing and putting it on its
books -- a rude surprise for investors. This might be particularly problematic for
companies that are short on cash or have properties whose values have fallen.

"There's nothing wrong with
them as a concept," says Gordon DuGan, president of W. P. Carey & Co., a New
York-based real-estate investment firm that helps companies get out of synthetic deals,
"but synthetic leases have a hidden balloon payment." Given these economic times
and the drop in real-estate values in some markets, "you don't want to have to make a
payment like that," he says.

Often, these deals lack
transparency because the liability a company may have isn't fully divulged. Concern about
disclosure prompted an about-face last week by Krispy Kreme Doughnuts Inc., whose previous
plan to finance the construction of $35 million manufacturing and distribution plant with
a synthetic lease came under fire, touched off by a Forbes magazine story.

The Winston-Salem, N.C., company
now says it will finance the facility with a traditional mortgage that will be reflected
in its financial statements.

Not Dettered

Other companies, meanwhile, plan
to proceed with their plans. In a filing with the Securities and Exchange Commission, Idec
Pharmaceuticals Inc. says it plans to develop a new $100 million headquarters campus in
the San Diego area and a $300 million to $400 million manufacturing facility in nearby
Oceanside, Calif., using "off-balance-sheet lease" arrangements.

Idec Pharmaceuticals Chief
Financial Officer Phillip Schneider says that while accountants and lawyers at the San
Diego-based biotech company have become "less comfortable" with synthetic
leases, "we're still looking at that as an option."

What's more, Mr. Schneider says,
"synthetic leases are much lower in cost to the company than a normal lease by about
4%."

Chiron Corp., another biotech
company, is proceeding with financing a more than $200 million expansion of its
Emeryville, Calif., headquarters, although the deal isn't yet completed, says John
Gallagher, a company spokesman.

Mr. Gallagher wouldn't comment on
Chiron's reasons for continuing with the synthetic lease deal, but he says the company is
"monitoring" reaction to synthetic leases "in light of recent events"
involving Enron's off-balance-sheet activity.

Bob,
I interested in your comment on synthetic leases. Anecdotal evidence
from my contacts in the Minneapolis/St. Paul area suggests that few
synthetic leases are done any more and some companies made big fees
unwinding existing ones. What did we miss?
K

It is my understanding that the synthetic leasing
industry brought pressures to bear, along with some other industries, to
continue to allow off-balance sheet accounting in SPEs (now VIEs) when
the FASB and the SEC began to consider the future of this entire
off-balance sheet ploy after the Enron fiasco.

Perhaps some of the synthetic leasing SPEs are unwinding
now because of the despised 10% outside investor rule used to be a 3%
rule. This complicates but does not eliminate off-balance sheet
accounting with VIEs.

Bob, The industry folks are
consistent with you on the significance of the increase from 3% to 10%
equity investment as an important reason for the demise of the synthetic
lease.

Interestingly, according to the
property guys who arranged these things, public companies were reluctant
to retain the arrangement, even if consolidation wasn't a problem,
because of the negativity associated with SPEs/VIEs after Enron. The
public companies maintained to the property guys that analysts had
enough info in the notes to capitalize the leases, so consolidation
didn't matter, it was that SPEs/VIEs gave the impression of bad
financial reporting and that did matter. K

FASB
significantly revamped its consolidation standards for variable interest
entities when it released Statement No. 167 in June 2009. Those standards
rework existing rules under FIN 46R for when a company must include a VIE on
its books with a potentially huge impact on corporate balance sheets.

The criteria
for determining an entity's VIE status have shifted, based now more on a
company's "obligations" and "power" over an entity than on ownership
percentage or absorption of losses. Complicating matters further are new
disclosure requirements to explain consolidation decisions.

New standards
cover fiscal years after Nov. 15, 2009, so they affect financials published
as soon as March or April 2010. Advisors must prepare now for the standards,
which require reevaluation of existing entity relationships, regardless of
whether VIEs were previously consolidated.

How Will This Statement Change
Current Practice?
This Statement amends Interpretation 46(R) to require an enterprise to
perform an analysis to determine whether the enterprise’s variable
interest or interests give it a controlling financial interest in a
variable interest entity. This analysis identifies the primary
beneficiary of a variable interest entity as the enterprise that has
both of the following characteristics:

a. The power to direct the
activities of a variable interest entity that most significantly
impact the entity’s economic performance

b. The obligation to absorb
losses of the entity that could potentially be significant to the
variable interest entity or the right to receive benefits from the
entity that could potentially be significant to the variable
interest entity. Additionally, an enterprise is required to assess
whether it has an implicit financial responsibility to ensure that a
variable interest entity operates as designed when determining
whether it has the power to direct the activities of the variable
interest entity that most significantly impact the entity’s economic
performance.

This Statement amends
Interpretation 46(R) to require ongoing reassessments of whether an
enterprise is the primary beneficiary of a variable interest entity.
Before this Statement, Interpretation 46(R) required reconsideration of
whether an enterprise is the primary beneficiary of a variable interest
entity only when specific events occurred. This Statement amends
Interpretation 46(R) to eliminate the quantitative approach previously
required for determining the primary beneficiary of a variable interest
entity, which was based on determining which enterprise absorbs the
majority of the entity’s expected losses, receives a majority of the
entity’s expected residual returns, or both.

This Statement amends certain
guidance in Interpretation 46(R) for determining whether an entity is a
variable interest entity. It is possible that application of this
revised guidance will change an enterprise’s assessment of which
entities with which it is involved are variable interest entities.

This Statement amends
Interpretation 46(R) to add an additional reconsideration event for
determining whether an entity is a variable interest entity when any
changes in facts and circumstances occur such that the holders of the
equity investment at risk, as a group, lose the power from voting rights
or similar rights of those investments to direct the activities of the
entity that most significantly impact the entity’s economic performance.

Under Interpretation 46(R), a
troubled debt restructuring as defined in paragraph 2 of FASB Statement
No. 15, Accounting by Debtors and Creditors for Troubled Debt
Restructurings, was not an event that required reconsideration of
whether an entity is a variable interest entity and whether an
enterprise is the primary beneficiary of a variable interest entity.
This Statement eliminates that exception.

This Statement amends
Interpretation 46(R) to require enhanced disclosures that will provide
users of financial statements with more transparent information about an
enterprise’s involvement in a variable interest entity. The enhanced
disclosures are required for any enterprise that holds a variable
interest in a variable interest entity. This

Statement nullifies FASB Staff
Position FAS 140-4 and FIN 46(R)-8, Disclosures by Public Entities
(Enterprises) about Transfers of Financial Assets and Interests in
Variable Interest Entities. However, the content of the enhanced
disclosures required by this Statement is generally consistent with that
previously required by the FSP.

How Will This Statement Improve
Financial Reporting?]This Statement amends Interpretation
46(R) to replace the quantitative-based risks and rewards calculation
for determining which enterprise, if any, has a controlling financial
interest in a variable interest entity with an approach focused on
identifying which enterprise has the power to direct the activities of a
variable interest entity that most significantly impact the entity’s
economic performance and (1) the obligation to absorb losses of the
entity or (2) the right to receive benefits from the entity. An approach
that is expected to be primarily qualitative will be more effective for
identifying which enterprise has a controlling financial interest in a
variable interest entity.

This Statement requires an
additional reconsideration event when determining whether an entity is a
variable interest entity when any changes in facts and circumstances
occur such that the holders of the equity investment at risk, as a
group, lose the power from voting rights or similar rights of those
investments to direct the activities of the entity that most
significantly impact the entity’s economic performance. It also requires
ongoing assessments of whether an enterprise is the primary beneficiary
of a variable interest entity. These requirements will provide more
relevant and timely information to users of financial statements.

This Statement amends
Interpretation 46(R) to require additional disclosures about an
enterprise’s involvement in variable interest entities, which will
enhance the information provided to users of financial statements.

What Is the Effect of This
Statement on Convergence with International Financial Reporting
Standards?The International Accounting Standards
Board (IASB) has a project on its agenda to reconsider its consolidation
guidance. The IASB issued two related Exposure Drafts, Consolidation
and Derecognition, in December 2008 and March 2009,
respectively. The IASB project on consolidation is a broader
reconsideration of all consolidation guidance (not just the guidance for
variable interest entities).

Although this Statement was not
developed as part of a joint project with the IASB, the FASB and IASB
continue to work together to issue guidance that yields similar
consolidation and disclosure results for special-purpose entities. The
ultimate goal of both Boards is to provide timely, transparent
information about interests in specialp purpose entities. However, the
timeline and anticipated effective date of the IASB project is different
from the effective date of this Statement.

This Statement addresses the
potential impacts on the provisions and application of Interpretation
46(R) as a result of the elimination of the qualifying special-purpose
entity concept in Statement 166. Ultimately, the two Boards will seek to
issue a converged standard that addresses consolidation of all entities.

Irrelevant if sponsor does not choose board or
have any involvement with SPE, if SPE has no discretion as to its activities and
operations.

Applies specifically to synthetic lease
transactions.

"Conduit" SPEs may be authorized and
utilized, so long as they are presently conducting activities for other sponsors.

Clarification and passage of Exposure Draft 154-D,
in a modified form, is expected in late 1998.

FASB Board believes there may be a presumption of
control if creator of SPE sets its policies and limits its purposes.

FASB plans to develop criteria for the purpose of
identifying a "qualifying special-purpose entity" and defining
"control" in circumstances involving SPEs.

Exposure Draft 194-B (Revised) (February 23,
1999).

Revision of EITF 154-D.

It states that "[f]or purposes of
consolidated financial statements, control involves decision-making ability that is not
shared with others."

Applies specifically to the creation of an SPE to
acquire, construct and use property where the creating entity has the nonshared ability to
guide the SPEs functions and the ability to increase the benefits it can derive and
limit the losses it can incur as the result of the way its directs those activities.

Example 7 contains a description of a
synthetic-lease transaction, involving the creation of an SPE, that would require
consolidation.

Example 7 also describes a scenario under which
three financial institutions form the SPE and none of them individually has the ability to
dominate the board of the SPE or control it; such an arrangement would not require
consolidation.

Often these structures are used
to finance specific assets or a revolving asset base transferred to the SPE. The transfer
of trade receivables, loans, or investment securities to the SPE would generally be
followed by the SPEs issuance of debt to investors secured by the transferred
assets. The borrower/transferor gains access to a source of funds less expensive than
would otherwise be available. This advantage derives from isolating the assets in an
entity prohibited from undertaking any other business activity or taking on any additional
debt, thereby creating a better security interest in the assets for the lender/investor.
SPE financing structures issue many forms of asset-backed securities, including
collateralized bond, debt, and loan obligations; and trade receivable commercial paper
conduits.

An SPE might be the lessor of a
property built for the specific needs of an identified lessee, such as a power plant or a
production facility. These transactions are often referred to as synthetic leases and
provide tax-advantaged financing lower than traditional mortgage loans. Another form of
tax-advantaged SPE transaction is the sale to an SPE of an asset that qualifies as a
financing under tax regulations, with any gain on sale deferred for tax purposes. These
are known as debt-for-tax transactions.

In September 2000, the Financial Accounting Standards Board
(FASB) issued FASB Statement No. 140, Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities. The FASB staff determined that the following
questions and answers should be issued as an aid to understanding and implementing
Statement 140 because of certain inquiries received on specific aspects of that
Statement.

The Board reviewed the following questions and answers in a
public meeting and did not object to their issuance. The questions and answers will be
included in a future edition of the FASB Staff Implementation

The staff has received
several inquiries relating to the consolidation of special-purpose entities
("SPEs"). As I discussed at this conference last year, when analyzing these
transactions, the staff looks to the guidance contained in EITF
Issue 90-15, Impact of Nonsubstantive Lessors, Residual
Value Guarantees, and Other Provisions in Leasing Transactions, EITF Topic D-14,
Transactions involving Special-Purpose Entities, and EITF Issue 96-21, Implementation
Issues in Accounting for Leasing Transactions involving Special-Purpose Entities. The
guidance in these EITF Issues discusses when a sponsor or transferor should consolidate an
SPE. In many SPE transactions, there are several parties involved, and it may not be clear
which party is the sponsor. Recently, the staff was asked for its views on how a
registrant should determine who is the sponsor of an SPE.

The staff believes that
registrants should not apply any one specific factor to determine the sponsor of an SPE,
and believes that all of the facts and circumstances of each transaction should be
considered carefully. In this regard, the staff believes registrants should consider the
following qualitative and quantitative factors in evaluating who the sponsor is of an SPE:

Qualitative Factors

Purpose. What is the business
purpose of the SPE? Name. What is the name of the SPE?

Name. What is the name of the
SPE?

Nature. What are the types of
operations being performed (for example, lending or financing operations, asset
management, and insurance or reinsurance operations)?

Referral Rights. Who has, and
what is the nature of, the relationships with third parties that transfer assets to or
from the SPE?

Asset Acquisition. Who has the
ability to control whether or not asset acquisitions are from the open market or from
specific entities?

Continuing Involvement. Who is
providing the services necessary for the entity to perform the nature of its operations,
and who has the ability to change the service provider (for example, asset management
services, liquidity facilities, trust services, financing arrangements)?

Placement of Debt Obligations.
Who is the primary arranger of the debt placement, and who performs supporting roles
associated with debt placement?

Quantitative Factors

Residual Economics. Who receives
the residual economics of the SPE including all fee arrangements?

Credit Facilities. Who
holds the subordinated interests in the SPE? In summary, the determination of who the
sponsor is in SPE transactions requires one to exercise sound professional judgment. The
qualitative and quantitative factors discussed above are not intended to be all-inclusive.
In analyzing these transactions, registrants should consider and weigh all the factors
noted above, among other items particular to the arrangement, before concluding on any
given set of facts and circumstances.

EITF 90-15. The Emerging Issues
Task Force ("EITF") of FASB has addressed circumstances under which the lessor
and the lessee are "consolidated" for financial accounting purposes. Under EITF
90-15, the lessee will not receive off-balance sheet accounting treatment if all of the
following tests are met:

Substantially all of the
activities of the lessor involve assets that are leased to the lessee.

The lessee bears substantially
all of the residual risks and enjoys substantially all of the residual benefits of the
leased assets.

The lessor has not made any
substantive investment that is at risk during the term of the lease.

The first test of EITF 90-15 is
met in a synthetic lease if the transaction is structured using an SPE as the lessor. In
addition, the triple-net lease meets the second test. With respect to the third test,
however, EITF 90-15 proposes three (3) percent as the minimum equity (now 10% after FASB Interpretation 46
in January 2003)that qualifies as a
"substantive" investment with the result that the typical synthetic lease SPE is
structured with a three percent equity contribution. When using a special purpose entity,
lessee will also be concerned that the transaction is structured to comply with the
February 23, 1999 FASB Exposure Draft on Consolidated Financial Statements which suggests
very clearly that under certain circumstances a three (3) percent equity contribution may
no longer be sufficient by itself to avoid consolidation.

The events and controversy
surrounding the bankruptcy of Enron have led many to believe that securitization and
structured finance serve no other purpose than deceit and deception. In reality, these are
modern business tools that, when properly deployed, allow corporate treasurers to transfer
risk, access alternative funding sources and capital markets, and maximally leverage a
corporations own expertise despite an inevitably limited capital base.

This article explains the
basic components of structured finance transactions and the sound reasons for their
undertaking from both an investor and originator perspective, and will also provide the
reader with examples of different common structures. Section II of this document describes
the basic mechanics and players inherent in nearly all securitizations and structured
transactions; the remaining sections of this document will discuss examples of different
types of structures. Section III discusses asset backed commercial paper (ABCPs) vehicles
and the important reasons for their evolution. Section IV will dissect a project finance
securitization, generally undertaken to specifically fund the project(s) in question.
Section V will discuss catastrophe linked bonds , or cats, as an example of a
means of shifting a risk concentration away from the originator and towards investors in
need of portfolio diversification.

Fundamental Components
of Securitization and Structured Transactions

Certain structural features are
common across all structured transactions. In each case, a separate entity is created in
which a population of assets or cash flows can be isolated. Commonly called a special
purpose vehicle or entity (SPV or SPE), the SPV then issues debt and/or equity
instruments to investors representing claims on the cash flows or assets isolated in the
SPV. The SPV is often a trust or corporation whose establishment is in the best interests
of both originator and investor.

A structure can be a cash
flow or synthetic securitization vehicle. In a cash flow-based
securitization, the ownership of the assets whose cash flows are to be securitized are
actually transferred to the SPV. In a synthetic securitization, by contrast,
the cash flows and/or economic exposure is transferred to the SPV through the use of a
total return swap or some other derivatives transaction. The two are equivalent from a
risk and return standpoint, but synthetic SPVs do not assume actual ownership of any
assets.

From the perspective of the
originator of a cash flow securitization, isolating the assets or cash flows in question
in an SPV is often a necessary step to achieve sales accounting treatment under GAAP and
thereby remove the assets in question from its balance sheet. From the investor
perspective, isolating the assets/cash flows serves to insulate the transaction from the
potential bankruptcy of the originator as well as its overall credit risk profile. In
doing so, it allows the investor to take on the isolated risk in the transaction in
question rather than the wider populations of risk that are probably inherent in direct
equity or debt investments of the originator. In addition, if the obligations of the cash
flow-backed SPV are to be more highly rated than the direct obligations of the originator,
complete isolation from the risk profile of the originator will be requisite.

Two additional players are almost
always present in each structured transactions, one to insure strict adherence to the
prescribed terms of the deal, the other to manage funds movement and cash flows. These are
the trustee and servicer, respectively. The trustee is an independent third party paid a
fee and retained from the onset of the transaction to essentially act as an advocate for
the SPVs security holders. The trustee monitors systematic reports by the servicer
tracking asset or pool performance, takes in cash flows collected by the servicer, and
acts to monitor the entire transaction on behalf of the security holder and in relation to
underlying legal indentures. Many structured finance transactions contain prescribed
trigger events- specifically identified events or performance measurements
that, when realized, may cause early liquidation or other actions to preserve the
interests of the security holder. It is the obligation of the trustee to track deal
performance, based on data provided monthly from the servicer, and take such actions as
legal covenants in the structure require to preserve the interests of the SPVs
security holders. Similarly, the trustee will take in cash flows collected and forwarded
by the servicer and pass them through to security holders, also as prescribed by terms of
the underlying structure and supporting legal documents.

The servicer in structured
transactions is often the originator of the assets in question. By way of example, assume
a bank bundles a population of residential mortgages it has originated, conveys them to an
SPV, and the SPV then issues securities representing the beneficial interests in the cash
flows eminating from those mortgages. Most commonly the originator is also the servicer-
in this case a bank. It allows the originator to enjoy fee income over the life of the
transaction, and in this case also keeps the bank customer from realizing some party other
than the bank has met its credit needs. That is, the mortgage obligor continues making
payments to the bank monthly as required; the bank, however, passes them through to the
trustee who, in turn, passes them along to the investor holding a security interest in the
cash flow stemming from that pool of mortgages. Notably, should the servicer fail to
perform as required in the legal documents, the trustee will be required to substitute
another servicer so as to preserve the security holders interests in the deal.

Finally, credit enhancements are
often indigenous to structured transactions and securitizations (and in many cases,
liquidity enhancement as well). Enhancements can be either externally provided by a third
party- such as a monoline insurer providing a credit default guarantee- or may be
internal to the deal. In the latter case, some mechanism(s) is established in
the deal design/engineering process to protect security holders from defaults in excess of
anticipated levels.

ENRON: AN ACCOUNTING ANALYSIS
OF HOW SPEs WERE USED TO CONCEAL DEBT AND AVOID LOSSES (This research report is not
free.)
In this special executive report, Gordon Yale, a forensic accounting expert, examines what
not to do with SPEs. His analysis, which looks at elements of the Powers Report, analyzes
Enron's use of SPEs, traces the short history of SPE misuse and focuses on controversial
gain-on-sale accounting common to many securitizations. Available at the FEI Research
Bookstore:http://www.fei.org/rfbookstore/default.cfm

Bass expressed his
discomfort in December 18, 1999, with Enron's aggressive hedging strategy for
derivatives. In a message to John Stewart, an Andersen partner in Chicago,
Bass said he told colleague David Duncan that he objected to using one
derivative to hedge another derivative. Duncan was the lead audit partner on
the Enron account.

Derivatives cannot
hedge derivatives for accounting purposes -- now or under FASB 133," Bass
said. "Does Dave [Duncan] think his accounting works even under FASB 133?
No way."

Both Bass and Duncan
reportedly are in talks with federal prosecutors and their testimony could be
used in the obstruction case against Andersen.

Andersen in January
fired Duncan for instigating the destruction of Enron Corp. documents.
Houston-based Enron allegedly used off-the-book transactions to hide $1
billion in debt and to inflate profits. Enron, once the nation's
seventh-largest company, filed the largest bankruptcy in U.S. history last
December.

Arthur Andersen,
Enron's auditor for 16 years, was hit with a federal indictment March 14 for
allegedly obstructing justice when it destroyed Enron documents. Andersen is
now near collapse and called off merger negotiations Tuesday with KPMG
International. The proposed Andersen-KPMG transaction would have combined the
two firms's non-U.S. partnerships.

In a February 1, 2000
e-mail to Stewart, Bass laid out issues he had with a "complicated series
of Enron derivatives." Three days later, Bass sent another message
stating he was "still bothered" with a partnership, SPE, and
believed it to be non-substantive.

Because of such
complaints, a senior Enron executive asked Duncan to remove Bass from any
review responsibility for the Enron account, the Wall Street Journal reported
Tuesday. Bass was removed in 2000, the WSJ said.

The Special
Investigative Committee of the Board of Directors
of Enron Corp. submits this Report of Investigation to the
Board of Directors. In accordance with our mandate, the Report addresses
transactions between Enron and investment partnerships created and
managed by Andrew S. Fastow, Enron's former Executive Vice President and
Chief Financial Officer, and by other Enron employees who worked with
Fastow.

The Committee
has done its best, given the available time and resources, to conduct a
careful and impartial investigation. We have prepared a Report that
explains the substance of the most significant transactions and
highlights their most important accounting, corporate governance,
management oversight, and public disclosure issues. An exhaustive
investigation of these related-party transactions would require
time and resources beyond those available to the Committee. We were not
asked, and we have not attempted, to investigate the causes of Enron's
bankruptcy or the numerous business judgments and external factors that
contributed it. Many questions currently part of public discussion--such
as questions relating to Enron's international business and commercial
electricity ventures, broadband communications activities, transactions
in Enron securities by insiders, or management of employee 401(k)
plans--are beyond the scope of the authority we were given by the Board.

There were
some practical limitations on the information available
to the Committee in preparing this Report. We had no power to compel
third parties to submit to interviews, produce documents, or otherwise
provide information. Certain former Enron employees who (we were told)
played substantial roles in one or more of the transactions under
investigation--including Fastow, Michael J. Kopper, Ben F. Glisan, Jr.
declined to be interviewed either entirely or with respect to most
issues. We have had only limited access to certain workpapers of Arthur
Andersen LLP ("Andersen"), Enron's outside auditors, and no
access to materials in the possession of the Fastow partnerships or
their limited partners. Information from these sources could affect our
conclusions. This Executive Summary and Conclusions highlights important
parts of the Report and summarizes our conclusions. It is based on the
complete set of facts, explanations and limitations described in the
Report, and should be read with the Report itself. Standing alone, it
does not, and cannot, provide a full understanding of the facts and
analysis underlying our conclusions.

On October 16,
2001, Enron announced that it was taking a $544 million alter-tax charge
against earnings related to transactions with LJM2 Co-Investment, L.P.
("LJM2"), a partnership created and managed by Fastow. It also
announced a reduction of shareholders' equity of $1.2 billion related to
transactions with that same entity.

Less than one
month later, Enron announced that it was restating its financial
statements for the period from 1997 through 2001 because of accounting
errors relating to transactions with a different Fastow partnership, LJM
Cayman, L.P. ("LJMI"), and an additional related-party entity,
Chewco Investments, L.P. ("Chewco"). Chewco was managed by an
Enron Global Finance employee, Kopper, who reported to Fastow.

The LJM1- and
Chewco-related restatement, like the earlier charge against earnings and
reduction of shareholders' equity, was very large. It reduced Enron's
reported net income by $28 million in 1997 (of $105 million total), by
$133 million in 1998 (of $703 million total), by $248 million in 1999
(of $893 million total), and by $99 million in 2000 (of $979 million
total). The restatement reduced reported shareholders' equity by $258
million in 1997, by $391 million in 1998, by $710 million in 1999, and
by $754 million in 2000. It increased reported debt by $711 million in
1997, by $561 million in 1998, by $685 million in 1999, and by $628
million in 2000. Enron also revealed, for the first time, that it had
learned that Fastow received more than $30 million from LJM1 and LJM2.
These announcements destroyed market confidence and investor trust in
Enron. Less than one month later, Enron filed for bankruptcy.

This Committee
was established on October 28, 2001, to conduct an investigation of the
related-party transactions. We have examined the specific transactions
that led to the third-quarter 2001 earnings charge and the restatement.
We also have attempted to examine all of the approximately two dozen
other transactions between Enron and these related-party entities: what
these transactions were, why they took place, what went wrong, and who
was responsible.

Our
investigation identified significant problems beyond those Enron has
already disclosed. Enron employees involved in the partnerships were
enriched, in the aggregate, by tens of millions of dollars they should
never have received--Fastow by at least $30 million, Kopper by at least
$10 million, two others by $1 million each, and still two more by
amounts we believe were at least in the hundreds of thousands of
dollars. We have seen no evidence that any of these employees, except
Fastow, obtained the permission required by Enron's Code of Conduct of
Business Affairs to own interests in the partnerships. Moreover, the
extent of Fastow's ownership and financial windfall was inconsistent
with his representations to Enron's Board of Directors.

This personal
enrichment of Enron employees, however, was merely one aspect of a
deeper and more serious problem. These partnerships---Chewco, LJM1, and
LJM2--were used by Enron Management to enter into transactions that it
could not, or would not, do with unrelated commercial entities. Many of
the most significant transactions apparently were designed to accomplish
favorable financial statement results, not to achieve bonafide economic
objectives or to transfer risk. Some transactions were designed so that,
had they followed applicable accounting rules, Enron could have kept
assets and liabilities (especially debt) off of its balance sheet; but
the transactions did not follow those rules.

Other
transactions were implemented--improperly, we are informed by our
accounting advisors--to offset losses. They allowed Enron to conceal
from the market very large losses resulting from Enron's merchant
investments by creating an appearance that those investments were
hedged--that is, that a third party was obligated to pay Enron the
amount of those losses---when in fact that third party was simply an
entity in which only Enron had a substantial economic stake. We believe
these transactions resulted in Enron reporting earnings from the third
quarter of 2000 through the third quarter of 2001 that were almost $1
billion higher than should have been reported.

Enron's
original accounting treatment of the Chewco and LJM1 transactions that
led to Enron's November 2001 restatement was clearly wrong, apparently
the result of mistakes either in structuring the transactions or in
basic accounting. In other cases, the accounting treatment was likely
wrong, notwithstanding creative efforts to circumvent accounting
principles through the complex structuring of transactions that lacked
fundamental economic substance. In virtually all of the transactions,
Enron's accounting treatment was determined with extensive participation
and structuring advice from Andersen, which Management reported to the
Board. Enron's records show that Andersen billed Enron $5.7 million for
advice in connection with the LJM and Chewco transactions alone, above
and beyond its regular audit fees.

Many of the
transactions involve an accounting structure known as a "special
purpose entity" or "special purpose vehicle" (referred to
as an "SPE" in this Summary and in the Report). A company that
does business with an SPE may treat that SPE as if it were an
independent, outside entity for accounting purposes if two conditions
are met: (1) an owner independent of the company must make a substantive
equity investment of at least 3% of the SPE's assets, and that 3% must
remain at risk throughout the transaction; and (2) the independent owner
must exercise control of the SPE. In those circumstances, the company
may record gains and losses on transactions with the SPE, and the assets
and liabilities of the SPE are not included in the company's balance
sheet, even though the company and the SPE are closely related. It was
the technical failure of some of the structures with which Enron did
business to satisfy these requirements that led to Enron's restatement.

In light of
considerable public attention to what has been described as a
"whistleblower" letter to Lay by an Enron employee, Sherron
Watkins, we set out the facts as we know them here. However, we were not
asked to, and we have not, conducted an inquiry into the resulting
investigation.

Shortly after
Enron announced Skilling's unexpected resignation on August 14, 2001,
Watkins sent a one-page anonymous letter to Lay sl/ The letter stated
that "Enron has been very aggressive in its accounting--most
notably the Raptor transactions." The letter raised serious
questions concerning the accounting treatment and economic substance of
the Raptor transactions (and transactions between Enron and Condor
Trust, a subsidiary of Whitewing Associates), identifying several of the
matters discussed in this Report. It concluded that "I am
incredibly nervous that we will implode in a wave of accounting
scandals." Lay told us that he viewed the letter as thoughtfully
written and alarming.

Lay gave a copy
of the letter to James V. Derrick, Jr., Enron's General Counsel. Lay and
Derrick agreed that Enron should retain an outside law firm to conduct
an investigation. Derrick told us he believed that Vinson & Elkins
("V&E") was the logical choice because, among other
things, it was familiar with Enron and LJM matters. Both Lay and Derrick
believed that V&E would be able to conduct an investigation more
quickly than another firm, and would be able to follow the road map
Watkins had provided. Derrick says that he and Lay both recognized there
was a downside to retaining V&E because it had been involved in the
Raptor and other LJM transactions. (Watkins subsequently made this point
to Lay during the meeting described below and in a supplemental letter
she gave to him.) But they concluded that the investigation should be a
preliminary one, designed to determine whether there were new facts
indicating that a full investigation--involving independent lawyers and
accountants--should be performed.

Derrick
contacted V&E to determine whether it could, under the legal ethics
rules, handle the investigation. He says that V&E considered the
issue, and told him that it could take on the matter. Two V&E
partners, including the Enron relationship partner and a litigation
partner who had not done any prior work for Enron, were assigned to
handle the investigation. Derrick and V&E agreed that V&E's
review would not include questioning the accounting treatment and advice
from Andersen, or a detailed review of individual LJM transactions.
Instead, V&E would conduct a "preliminary investigation,"
which was defined as determining whether the facts raised by Watkins
warranted further independent legal or accounting review.

Watkins
subsequently identified herself as the author of the letter. On August
22, one week after she sent her letter, she met with Lay in his office
for approximately one hour. She brought with her an expanded version of
the letter and some supporting documents. Lay recalls that her major
focus was Raptor, and she explained her concerns about the transaction
to him. Lay believed that she was serious about her views and did not
have any ulterior motives. He told her that Enron would investigate the
issues she raised,

V&E began
its investigation on August 23 or 24. Over the next two weeks, V&E
reviewed documents and conducted interviews. V&E obtained the
documents primarily from the General Counsel of Enron Global Finance. We
were told that V&E, not Enron, selected the documents that were
reviewed. V&E interviewed eight Enron officers, six of whom were at
the Executive Vice President level or higher, and two Andersen partners.
V&E also had informal discussions with lawyers in the firm who had
worked on some of the LJM transactions, as well as in-house counsel at
Enron. No former Enron officers or employees were interviewed. We were
told that V&E selected the interviewees.

After
completing this initial review, on September 10, V&E interviewed
Watkins. In addition, V&E provided copies of Watkins' letters (both
the original one-page letter and the supplemental letter that she gave
to Lay at the meeting) to Andersen, and had a follow-up meeting with the
Andersen partners to discuss their reactions. V&E also conducted
follow-up interviews with Fastow and Causey.

On September
21, the V&E partners met with Lay and Derrick and made an oral
presentation of their findings. That presentation closely tracked the
substance of what V&E later reported in its October 15, 2001 letter
to Derrick. At Lay's and Derrick's request, the V&E lawyers also
briefed Robert Jaedicke, the Chairman of the Audit and Compliance
Committee, on their findings. The lawyers made a similar presentation to
the full Audit and Compliance Committee in early October 2001.

V&E
reported in writing on its investigation in a letter to Derrick dated
October 15, 2001. The letter described the scope of the undertaking and
identified the documents reviewed and the witnesses interviewed. It then
identified four primary areas of concern raised by Watkins: (1) the
"apparent" conflict of interest due to Fastow's role in LJM;
(2) the accounting treatment for the Raptor transactions; (3) the
adequacy of the public disclosures of the transactions; and (4) the
potential impact on Enron's financial statements. On these issues,
V&E observed that Enron's procedures for monitoring LJM transactions
"were generally adhered to," and the transactions ''were
uniformly approved by legal, technical and commercial professionals as
well as the Chief Accounting and Risk Officers." V&E also noted
the workplace "awkwardness" of having Enron employees working
for LJM sitting next to Enron employees.

on the conflict
issues, V&E described McMahon's concerns and his discussions with
Fastow and Skilling (described above), but noted that McMahon was unable
to identify a specific transaction where Enron suffered economic harm.
V&E concluded that "none of the individuals interviewed could
identify any transaction between Enron and LJM that was not reasonable
from Enron's standpoint or that was contrary to Enron's best
interests." on the accounting issues, V&E said that both Enron
and Andersen acknowledge "that the accounting treatment on the
Condor/Whitewing and Raptor transactions is creative and aggressive, but
no one has reason to believe that it is inappropriate from a technical
standpoint." V&E concluded that the facts revealed in its
preliminary investigation did not warrant a "further widespread
investigation by independent counsel or auditors," although they
did note that the "bad cosmetics" of the Raptor related-party
transactions, coupled with the poor performance of the assets placed in
the Raptor vehicles, created "a serious risk of adverse publicity
and litigation."

V&E
provided a copy of its report to Andersen. V&E also met with Watkins
to describe the investigation and go over the report. The lawyers asked
Watkins whether she had any additional factual information to pass
along, and were told that she did not.

With the
benefit of hindsight, and the information set out in this Report,
Watkins was right about several of the important concerns she raised. On
certain points, she was right about the problem, but had the underlying
facts wrong. In other areas, particularly her views about the public
perception of the transactions, her predictions were strikingly
accurate. Overall, her letter provided a road map to a number of the
troubling issues presented by the Raptors.

The result of
the V&E review was largely predetermined by the scope and nature of
the investigation and the process employed. We identified the most
serious problems in the Raptor transactions only after a detailed
examination of the relevant transactions and, most importantly,
discussions with our accounting advisors--both steps that Enron
determined (and V&E accepted) would not be part of V&E's
investigation. With the exception of Watkins, V&E spoke only with
very senior people at Enron and Andersen. Those people, with few
exceptions, had substantial professional and personal stakes in the
matters under review. The scope and process of the investigation appear
to have been structured with less skepticism than was needed to see
through these particularly complex transactions.

I am submitting testimony in response to this
Committee’s request that I address potential problems associated with the
unregulated status of derivatives used by Enron Corporation. . . . In short,
Enron makes Long-Term Capital Management look like a lemonade stand.
Testimony of Frank Partnoy Professor of Law, University of San Diego School of
Law Hearings before the United States Senate Committee on Governmental Affairs,
January 24, 2002 --- http://www.senate.gov/~gov_affairs/012402partnoy.htm

I
am a law professor at the University of San Diego School of Law.I teach and research in the areas of financial market regulation,
derivatives, and structured finance.During the mid-1990s, I worked on Wall Street structuring and selling
financial instruments and investment vehicles similar to those used by Enron.As a lawyer, I have represented clients with problems similar to
Enron’s, but on a much smaller scale.I have never received any payment from Enron or from any Enron officer
or employee.

Enron has been compared to Long-Term Capital Management, the Greenwich,
Connecticut, hedge fund that lost $4.6 billion on more than $1 trillion of
derivatives and was rescued in September 1998 in a private bailout engineered
by the New York Federal Reserve.For the past several weeks, I have conducted my own investigation into
Enron, and I believe the comparison is inapt.Yes, there are similarities in both firms’ use and abuse of financial
derivatives.But the scope of Enron’s problems and their effects on its investors
and employees are far more sweeping.

According to Enron’s most recent annual report, the firm made more money
trading derivatives in the year 2000 alone than Long-Term Capital Management
made in its entire history.Long-Term Capital Management generated losses of a few billion dollars;
by contrast, Enron not only wiped out $70 billion of shareholder value, but
also defaulted on tens of billions of dollars of debts.Long-Term Capital Management employed only 200 people worldwide, many
of whom simply started a new hedge fund after the bailout, while Enron
employed 20,000 people, more than 4,000 of whom have been fired, and many more
of whom lost their life savings as Enron’s stock plummeted last fall.

It
will surprise many investors to learn that Enron was, at its core, a
derivatives trading firm.Nothing made this more clear than the layout of Enron’s extravagant
new building – still not completed today, but mostly occupied – where the
top executives’ offices on the seventh floor were designed to overlook the
crown jewel of Enron’s empire: a cavernous derivatives trading pit on the
sixth floor.

I believe there are two answers to the question of why Enron collapsed, and
both involve derivatives.One relates to the use of derivatives “outside” Enron, in
transactions with some now-infamous special purpose entities.The other – which has not been publicized at all – relates to the
use of derivatives “inside” Enron.
Derivatives are complex financial instruments whose value is based on one or
more underlying variables, such as the price of a stock or the cost of natural
gas.Derivatives
can be traded in two ways: on regulated exchanges or in unregulated
over-the-counter (OTC) markets.My testimony – and Enron’s activities – involve the OTC
derivatives markets.

Sometimes OTC derivatives can seem too esoteric to be relevant to average
investors.Even
the well-publicized OTC derivatives fiascos of a few years ago – Procter
& Gamble or Orange County, for example – seem ages away.
But the OTC derivatives markets are too important to ignore, and are critical
to understanding Enron.The size of derivatives markets typically is measured in terms of the
notional values of contracts.Recent estimates of the size of the exchange-traded derivatives market,
which includes all contracts traded on the major options and futures
exchanges, are in the range of $13 to $14 trillion in notional amount.By contrast, the estimated notional amount of outstanding OTC
derivatives as of year-end 2000 was $95.2 trillion.And that estimate most likely is an understatement.

In other words, OTC derivatives markets, which for the most part did not exist
twenty (or, in some cases, even ten) years ago, now comprise about 90 percent
of the aggregate derivatives market, with trillions of dollars at risk every
day.By
those measures, OTC derivatives markets are bigger than the markets for U.S.
stocks.
Enron may have been just an energy company when it was created in 1985, but by
the end it had become a full-blown OTC derivatives trading firm.Its OTC derivatives-related assets and liabilities increased more than
five-fold during 2000 alone.

And, let me repeat, the OTC derivatives markets are largely
unregulated.Enron’s trading operations were not regulated, or even recently
audited, by U.S. securities regulators, and the OTC derivatives it traded are
not deemed securities.OTC derivatives trading is beyond the purview of organized, regulated
exchanges.Thus,
Enron – like many firms that trade OTC derivatives – fell into a
regulatory black hole.

After 360 customers lost $11.4 billion on derivatives during the decade
ending in March 1997, the Commodity Futures Trading Commission began
considering whether to regulate OTC derivatives.But its proposals were rejected, and in December 2000 Congress made the
deregulated status of derivatives clear when it passed the Commodity Futures
Modernization Act.As a result, the OTC derivatives markets have become a ticking time
bomb, which Congress thus far has chosen not to defuse.

Many parties are to blame for Enron’s collapse.But as this Committee and others take a hard look at Enron and its
officers, directors, accountants, lawyers, bankers, and analysts, Congress
also should take a hard look at the current state of OTC derivatives
regulation.(In
the remainder of this testimony, when I refer generally to “derivatives,”
I am referring to these OTC derivatives markets.)

Frank Partnoy is best known as a whistle blower at Goldman Sachs who blew the
lid on the financial graft and sexual degeneracy of derivatives instruments
traders and analysts who ripped the public off for billions of dollars and
contributed to mind-boggling worldwide frauds. He is a Yale University Law
School graduate who shocked the world with various books include the
following:

Andersen's negative response to the above report --- Statement of C. E. Andrews, Global Managing Partner, in response to
Enron special committee report February 2, 2002  The report issued today by
Enrons special committee is troubling on many levels. Nothing more than a
self-review, it does not reflect an independently credible assessment of the situation,
but instead represents an attempt to insulate the companys leadership and the Board
of Directors from criticism by shifting blame to others.http://www.andersen.com/website.nsf/content/MediaCenterEnronResources!OpenDocument

Under pressure to set accounting standards for
the kinds of special purpose entities that kept debt off Enron's balance sheet, the
Financial Accounting Standards Board, in February 2002, has tentatively decided on
an approach and directed its staff to begin writing an exposure draft. http://www.accountingweb.com/item/72237

The press
calls them "off-balance-sheet partnerships"--those hundreds of Enron entities
that were used to hide its debt and book illusory profits. On Wall Street, though, they're
known as special purpose entities, or SPEs, and you'd be hard-pressed to find a FORTUNE
500 company that doesn't use one. Are they all as bad as Enron's? Thankfully, no. But they
offer plenty of temptation for companies looking for legal ways to cook the books.

Like many complex instruments, SPEs were created
to perform a straightforward, necessary task--isolating and containing financial risk.
Businesses that wanted to perform a specialized task--an airline buying a fleet of
airplanes; a company building a big construction project--would set up an SPE and offload
the financing to the new entity. For example, a company looking to build a gas pipeline
but not wanting to assume all the debt load would set up an SPE--essentially, a joint
venture with other investors--to build it. The SPE would own the pipeline and use it as
collateral to issue the bonds to finance it. The sponsoring company would still operate
the pipeline, with the revenues being used to pay back the bondholders.

In theory, SPEs protected both sides of the
transaction if something went awry. If the project went bust, the company was responsible
only for what it had put into the SPE; conversely, if the company went bankrupt, its
creditors couldn't go after the SPE's assets.

Over time, SPEs became essential components of
modern finance. Their uses expanded wildly--and legitimately. For example, virtually every
bank uses SPEs to issue debt secured by pools of mortgages. And companies as diverse as
Target and Xerox use SPEs for factoring--the centuries-old practice of generating cash by
selling off receivables.

But SPEs also evolved into an effective scalpel
for CFOs looking to perform cosmetic surgery on their balance sheets. That's because the
accounting rules say that as long as a company owns less than 50% of an SPE's voting
stock, the SPE's assets and debt don't have to be consolidated on its books. In fact, due
to a particularly egregious accounting reg, the SPE's nominal owner--usually some friendly
outside investor--needs to put up only 3% (now 10%) of the SPE's equity. The company
establishing it can contribute the remaining 97%, and it still qualifies for
off-balance-sheet treatment.

Today many transactions between companies and
their SPEs do not isolate risk at all; their primary purpose is to hide pertinent
information from investors. Take factoring again. The sponsoring company usually provides
the SPE's bondholders with guarantees called credit enhancements, which are promises to
maintain the value of the SPE's assets at some minimal level. In more complicated SPEs,
such as some of Enron's, options or derivatives are used to guarantee the bondholders'
returns. Amazingly, this practice is technically allowable.

SPEs are also a good way to keep money away from
Uncle Sam. Most tax-avoidance techniques using SPEs cleverly exploit discrepancies between
accounting rules and tax laws. Synthetic leases are a good example. These are transactions
in which a company sells an asset to an SPE and then leases it back. The company gets to
move the asset off its balance sheet--yet for tax purposes it retains the ability to
depreciate the asset as if it were still the owner.

Enron employed all these tactics and then some.
It even sold dubious assets to its SPEs at inflated prices to produce bogus income. And it
had almost 900 off-balance-sheet partnerships located in international tax havens, a fact
that mystifies most experts. "If a company has four or five of these things, that
would be a lot," says Allen Tucci, a partner at Tucci & Tannenbaum, a
Philadelphia law firm that helps set up SPEs.

Enron also appears to have stretched the rules
well past the breaking point. It used side agreements to set up SPEs that didn't even
clear the 3% (now 10%) hurdle. And many of its partnerships were designed to create the
appearance that the SPE's investors and bondholders were assuming risks when, in fact,
Enron retained most--and in some cases all--of them.

The full story of what Enron did with its SPEs
will undoubtedly emerge in the coming months. In the meantime, the Feds are finally
cracking down. Late last month, PNC Bank took a $155 million hit to its earnings. Why?
Because the SEC and the Federal Reserve forced it to reinclude three SPEs on its balance
sheet.

I asked a former Chairman of the Financial
Accounting Standards Board to provide me with his off-the-wall remembrances of the history
of SPEs in the United States. His reply is shown below.

Reflections of SPE History by Dennis
Beresford

Bob,

I'm not really an expert in this area but
I'll share some of my limited knowledge. The 3% (now 10%) rule came about as a result of
EITF deliberations a few years ago regarding special purpose leasing entities. These
involved things like major power plants and the like. The sponsor enters into an operating
lease with the SPE that falls just short of meeting the capitalization rules. Most of the
financing for the SPE is non-recourse (to the sponsor) debt but the EITF insisted that
some unrelated party put some of its own capital at risk - hence the 3% (now 10%). That
may not sound like much but it can be a large dollar investment because many of these
projects are huge.

Of course, you and others might
ask why the sponsor shouldn't capitalize the lease because it is in substance a purchase.
That debate may occur again in the future but for now we live with FASB Statement 13 that
requires that such leasing arrangements be well disclosed but not recorded as assets and
liabilities if all of the tests in 13 are met. Some of the rating agencies and other users
of financial statements do their own capitalization procedures to figure out an effective
debt-equity ratio assuming that the leases were capitalized.

Another large segment of the SPE
universe involves what are known as take or pay contracts. Again, the SPE is a separate
legal entity with substantial non-recourse financing and at least 3% (now 10%) independent
equity. In these cases, the sponsor agrees to purchase a certain level of the output of
the plant at agreed upon prices. These would represent fixed purchase orders that again
should be disclosed in the financial statements (I forget the specific accounting standard
that requires this).

The Enron SPE's, based on my very
limited understanding, were quite different than the two types mentioned above. First, at
least some of them involved Enron selling assets to the SPE and recording significant
profits. That's apparently why income statements had to be restated when the SPE's were
consolidated by Enron. Normally, SPE's are a form of off-balance sheet financing but they
don't cause differences in reported income. A second difference in Enron's case involves
the guarantees that Enron made to issue its own stock if things didn't go well for the
SPE's. I don't really understand these particulars yet, but they certainly seem to be
quite different than the more typical types of SPE's mentioned earlier.

Of course, a third major
difference between Enron and most others involves the related parties who were principals
of the SPE's, particularly the former CFO.

I'm not aware of any good
articles about the benefits of using SPE's. I suspect that the Big 5 firms and the
investment bankers have such materials but many of them involve proprietary products
perhaps similar to what got Enron in trouble.

I hope this helps a little. This
is a fascinating subject and we will all be learning more as matters unfold.

Denny

Reflections of Consolidations History by
Dennis Beresford

Bob,

Some of the postings on AECM and some of
the articles in the press suggest that the Enron mess could have been avoided if only the
FASB had come up with better consolidation rules some time ago. Those comments caused me
to want to describe, at least briefly, some of the problems faced in this area and the
history of the consolidation project. Feel free to share this in your Bookmarks or
otherwise if you want.

First, it is interesting to note
that the 20th anniversary of the FASB's consolidations project occurs this month. I don't
remember the specific day, but it was sometime in January 1982 when the Board voted to add
a project to its agenda to improve consolidation accounting. Much of the impetuous for
that project came from a series of AICPA Issues Papers that pointed out certain practice
problems associated with consolidation, such as whether income should be recognized when a
subsidiary sells a portion of its equity to independent investors and how to best account
for intercompany transactions. I was a member of the AICPA committee that developed those
position papers and I was in favor of the Board looking into consolidation. I should add,
however, that these were mainly consolidation procedures matters and not the basic
consolidation policy matter - on what basis should consolidation take place.

One of the most controversial
issues at that time was the non-consolidation of finance and leasing subsidiaries on the
basis that their operations were so different from the manufacturing or other operations
of the parent that consolidation would not be meaningful. Examples were GMAC and GE
Capital. During my first year at the FASB (1987), we finalized Statement 94, which
required consolidation of all majority-owned subsidiaries such as those just mentioned. In
that Statement the Board said that it felt that consolidation based on control was the
most appropriate approach but it hadn't yet been able to agree on what that meant so
Statement 94 was intended to be an interim step while the Board worked to refine the
notion of control.

I should back up a step at this
point to observe that before I joined the Board there had been a lot of research done on
the conceptual basis for consolidation. That resulted in a never published research report
that concluded there were two basic approaches: the parent company approach and the
reporting entity approach. Depending on which of these approaches you prefer, you will get
different answers on what entities should be included in consolidated financial
statements. You'll also get dramatically different reported results for such things as
intercompany gains and losses and minority interest. Most Board members (not me) preferred
the reporting entity approach while most constituents have continued to believe that the
parent company approach is the only logical one.

In any event, after Statement 94
was issued, the Board continued to debate consolidation and did so for the rest of my ten
years as Chairman. An exposure draft was eventually issued that would have required
consolidation based on control and would have adopted the reporting entity concept so that
consolidation procedures would have been dramatically revised. I dissented to that ED.
Nearly all constituents strongly opposed the ED and the Board was not able to reach
agreement on either a final statement or a revised ED before I left. Keep in mind that the
project was always dealing with all aspects of consolidation and even back then a number
of constituents were telling the Board that it should leave well enough alone with respect
to general consolidation but it should do something about the developing matter of special
purpose entities.

After I left the Board members
continued to debate these matters. A decision was made to limit the scope of the project
to consolidation policy (what to consolidate) and leave the consolidation procedures
(minority interest, etc.) for later consideration. That ED was also generally rejected by
constituents. To give you and other interested parties an idea of the continuing problems,
I've attached a copy of the comment letter I wrote to the Board on the most recent
exposure draft. Yes, former Board members are entitled to express their views, and, yes,
the Board is free to ignore them!

I should digress for a moment
here and point out that almost no academics ever comment on FASB proposals. Similar to
exchanges on AECM and newspaper articles, it is relatively easy to bat out a short
criticism about a topic. However, it's much more challenging to study the matter in
question in depth and to develop a thoughtful and persuasive commentary.

The FASB has continued to debate
the consolidation issues from its latest ED and several months ago it announced that it
didn't have enough support (at least 5 members in favor) to be able to issue a final
statement. Then there was a turnover of three (of 7) Board members in July and September
and the Board said it will begin talking about these matters again given the presence of
three individuals with no previous position on the matter. The Board also said it would
look first at special purpose entities and similar practice problems to see if interim
guidance on those problems could be issued before getting back into the more general
matters.

All of the above is not intended
to apologize for the FASB's activities on this project or to criticize them. Neither do I
feel a need to excuse my own positions. However, I think the above does point out that
this is an extremely difficult topic and reasonable people can disagree. In fact, one of
my principal reservations about the control approach to consolidation is that two parties
can read the same "guidance" and reach the opposite conclusion as to whether
consolidation is required. While I believe strongly that judgment should play an important
role in applying accounting standards, I think a standard that can't be applied with any
sort of reasonable consistency is much worse than a relatively bright line (e.g., 50%
ownership) that is applied rigidly even if it leaves out some entities that arguably could
have been consolidated.

I apologize for getting a little
carried away with this message but I hope it may be helpful to you or others. I guess that
one of the things I like about being an academic is that I'm pretty much free to spend my
time on things like this - as long as I do it at 6:30 in the morning!

Denny

Reply from Robert Walker in New Zealand

Thank you for
sharing Mr Beresford's letter. As a person operating in a jurisdiction long used to an
'in-substance' approach to consolidation, I have little sympahty with the narrow notion of
a reporting group based on the parent entity - though I know it is favoured in North
America.

The notion of
control is built not only into our accounting rules (which have the force of law) but also
directly into corporate law itself. That is a group is defined not only by ownership
arrangement but also by a control relationship. Unfortunately there is no consideration,
to my knowledge, in the courts as to what this might mean.

Our derivative of the conceptual
framework (which in my view forms part of legally binding GAAP) goes much further even
that the notion of control. It defines the reporting entity as follows:

'A reporting entity exists where
it is reasonable to expect the existence of users dependent on general purpose financial
reports for information which will be useful to them in terms of the objectives [of
financial reporting].'

For a commercial perspective, the
problems of operationalising this definition are formidable and, frankly, the
consolidation standards don't really deal with it properly. Nevertheless the definition
does make some sense in the public sector context. In saying this what needs to be borne
in mind is that the genealogy of the NZ definition can be traced directly to the work of
Dr Ian Ball - a public sector accounting specialist and a man who is extremely influential
in our standard setting establishment as he is (or was) in IFAC's public sector standard
setting. He wrote an interesting monograph for the AARB (from memory) entitled The
Reporting Entity.

Dr Ball ultimately was attempting
to equip our government with what is known as sectoral accounting. His theory is basically
that a government should be informed about each sector within its broad jurisdiction -
that is health, education or whatever. This is has never been properly developed though it
does exist in part. The NZ Public Finance Act 1989 does require a sectoral report to be
prepared for all NZ schools. This necessitates that all 3,000 odd schools, even though
they are semi-autonomous, have to prepare a financial report to a uniform standard (they
are subject to legally imposed and defined GAAP). This is then consoldiated by the central
Ministry.

In essence what I shall call the
user theory goes on step further than the entity theory. In the latter there is a single
axis around which the reporting entity coalesces - generally this will be the central
controlling authority like a company board. In the former the reporting entity is
multi-axis. There is no central controlling authority.

I myself tested the limits of Dr
Ball's user theory in one of the few places I would be allowed to be let loose with some
of my more arcane theoretical perspectives. I tried it in my own local school whose baord
I was on. NZ schools have a dual fund raising capacity - there is the mainstream funding
from government and then there is local fund raising, generally under the control of a
semi-autonomous group of parents. Because of the extreme difficulties of auditing
uncontrolled local fund raising, the schools financial reports are invariably prepared
only on the basis of the government funding.

I decided that the definition
included in our GAAP required application of the user theory. I prepared the report to
display all resources available to the school not just those from government. The
government's auditor refused to accept it and forced me to prepare a report of the
narrower entity. I then has a four column report for a tiny school. The effort was
unsustainable as the government's auditor well knew. In short, the government auditor let
expediency over-ride what is legally binding for a simpler life. Who can blame them.

It does, of course, prove that
the practical world of accounting does not like to subject to the logical extensions of
theory even if it is written directly into the canon.

One final thought - it has always
occurred to me that our banks, being subject to the wider control criterion for
consolidation, should consolidate all those advances where they are in effective control
rather than account for them as pure advances. Of course this doesn't happen. Funny that.

One of the things that I find
most fascinating about the Enron/Andersen saga is how much inside information is being
made public (thanks to our electronic age). Yesterday the House Energy and Commerce
Committee released a series of internal Andersen memos showing the dialogue between the
executive office accounting experts and the Houston office client service people. While I
haven't had a chance to read all 94 pages yet, the memos are reported to show that the
executive office experts raised significant questions about Enron's accounting. But the
Houston people were able to ignore that advice because Andersen's internal policies
required the engagement people to consult but not necessarily to follow the advice they
received. As far as I know, all other major accounting firms would require that
consultation advice be followed.

Thank you for I'm not sure how
far you got through the material, but to help others find their way, I suggest the most
salient pages explaining how the SPEs work and the decisions that were made be read in the
following order: 1. Enron transaction by Bass 2/1/00 (p.4 of all 95 pages if you download
them all-about 2 megs) 2. Enron option by Bass 12/18/99 (p.1,2 of 95) 3. Enron by Bass
3/4/01 #3 "raptor" (p.11-12 of 95) which documents that $100 million in losses
was hidden in one transaction. 4. Re: Enron Derivative Transaction by Bass 2/4/00 (p.7 of
95)

The problem with these specific
SPEs was that they were not truly independent in the sense that even the minimal amount of
outside investment required under GAAP was not actually there. Some of it had already been
repaid before any transactions took place, some if it was under the control of an Enron
related party (Fastow and/or Kopper). Finally, the problem with some of the raptors was
that Enron was pretending to hedge fluctuations in its New Power with an SPE that had as
its only asset New Power stock.. Tricky to do.

Re: independence, had there been
10% rather than 3% (now 10%), would that have made the transactions OK from a GAAP point
of view? It wouldn't have made a bit of difference in terms of what actually happened,
since once you accept the hedge as unrelated (whatever the criteria), the only issue left
is what level of assets in total are available to cover the derivative liability. Thus,
while important, I don't think independence at the heart of the problem, which leads to
your second point, and my question, concerning the nature of the assets in the SPE. The
fact that it was Enron stock is the issue. While I can reason out from first principles
why changes in the value of one's stock shouldn't lead to changes in income and expense,
there are exceptions. A current example is the push for the cost of executive stock
options to be treated as an expense rather than a capital. So it is not entirely clear.
And given the US's emphasis on official pronouncements, they become particularly salient,
hence my question to Bob and the list.

Another question: what if Enron
had done the same deals using the stock of another firm in the same industry, rather than
Enron's stock? Then it would be acceptable? But we would have had the same outcome-the
losses would be covered until the other firm's stock tanked, with similar measurement and
disclosure, and again, a big disaster.

If we don't identify and address
the real problems, we can be sure they will recur.

Best regards,

Kevin

FEI's Document of
Understanding SPEs

The Financial Executives Institute issued its own
explanatory report on SPEs in January 2002 in the wake of the Enron scandal. It
attempts to explain why they are used, how they are used, and the background of standards
literature on this topic. Go to http://www.fei.org/download/SPEIssuesAlert.pdf

Two excerpts are quoted below:

SPE Usage
To illustrate how an SPE is commonly used in the financial marketplace, consider the
following example of a financial asset securitization. Typically, in these types of
transactions the SPE is formed to facilitate the sale of specific financial assets
belonging to the sponsor company. The assets are sold to the SPE and could include trade
accounts receivable, equity securities, notes receivable, etc. A minimum 3% (now 10%)
investment from an independent third-party investor is contributed, representing a legal
equity ownership interest in the SPE. The 3% (now 10%) is based on the fair value of the
financial assets to be sold.

In exchange for its investment,
the third-party equity investor controls the SPE activities and retains the substantial
risks and rewards of its ownership in the SPE assets. For an SPE to be an arms length
entity, not consolidated into the sponsors financial statement, the third-party
investor must bear the risk of its investment. If an investor contributes equity as a note
payable to the SPE or secures the investment by a letter of credit, insurance or
guarantee, the investment would not be considered at risk. Once the 3% (now
10%) is established, the SPE then finances the remaining funds to acquire the financial
assets from the sponsoring company by issuing debt and/or additional equity to
institutional investors or public shareholders.

As long as the specific
qualifications are met, the assets and the corresponding debt and equity of the SPE
achieve off-balance sheet treatment with respect to the sponsors financial
statements. Further, if the SPE has no indebtedness other than the asset-secured loan and
routine trade payables, the SPE is unlikely to become insolvent as a result of its
activities being limited. Therefore, in financial asset securitizations, SPEs provide the
sponsor the ability to legally isolate a group of assets from the sponsors
bankruptcy risk and to reflect the transfer of financial assets as a sale in its financial
statements.

When SPE assets are protected,
SPE credit quality is enhanced. Thus financing costs on debt incurred by the SPE are
reduced. For an even lower interest rate paid on the debt, the SPE will obtain credit
enhancements in the form of recourse debt, subordinate assignments or guarantees, either
from the transferor or other third parties. The reduction of credit risk and the
marketability of the SPE equity generally diminishes the cost of the capital to a level
below that the sponsor would have achieved on its own. Again, it should be noted that such
credit enhancement features typically should not be extended to the 3% (now 10%) equity
investor as this investment must be at risk in order for the SPE to be
eligible for deconsolidation by the transferor. The prior example is one of the many types
of transactions that use an SPE. The form of the SPE and the structure of the transaction
can be vastly different for SPEs used in off-balance sheet activities and leasing
arrangements.

The First American Title
Insurance Company and Commercial Mortgage Insight offer specifics with regard to the
synthetic-leasing and commercial-mortgage-backed securities area. With these particular
industries, loan underwriters and/or credit rating agencies require borrowing entities to
be SPEs. Lenders and agencies often demand that the SPE appoint at least one independent
controlling person who is not affiliated with the sponsor company. The SPE's
organizational documents provide for a unanimous or significant majority vote or consent
of the SPE members to approve any bankruptcy filing or any disposition of assets. Loan
documents may have other restrictions regarding M&A activity and commingling assets or
contracting with affiliates.

SPEs can create tax advantages
for the transferor. As a pass-through entity, the SPE is not taxed at the entity level.
The initial documentation alone could make the SPE an expensive conduit. But given the
typical size of the SPE transactions and the benefits of the interest rate reduction plus
tax savings, the benefits are likely to outweigh the maintenance costs.

Existing Accounting Guidance
for SPEs
Accounting for SPEs involves a two-step approach. The first is identification of the SPE
sponsor. Owing to the number of parties involved in some SPEs, the sponsor may not be
easily determined. In this regard, the staff of the SEC Office of the Chief Accountant
refers to following Emerging Issues Task Force (EITF) guidance:

· Name and Purpose . What is the
name and business purpose of the SPE?

· Nature. What are the types of
operations performed (for example, lending or financing operations, asset management, and
insurance or reinsurance operations)?

· Referral Rights. Who has, and
what is the nature of, the relationships with third parties that transfer assets to or
from the SPE?

· Asset Acquisition. Who has the
ability to control whether or not asset acquisitions are from the open market or from
specific entities?

· Continuing Involvement. Who is
providing the services necessary for the entity to perform its operations and who has the
ability to change the service provider (e.g., asset management services, liquidity
facilities, trust services, financing arrangements)?

· Placement of Debt Obligations.
Who is the primary arranger of the debt placement and who performs supporting roles
associated with debt placement?

· Residual Economics. Who
receives the residual economics of the SPE including all fee arrangements? · Fee
Arrangements. Who receives fees for asset management, debt placement, trustee services,
referral services, and liquidity/credit enhancement services? How are the fee arrangements
structured? · Credit Facilities. Who holds the subordinated interests in the
SPE?

The second and more complicated
step is deciding when an SPE should be included in the sponsors consolidated
financial statements. Consolidation results in the sponsor recognizing SPE assets and
obligations, and eliminating the effects of any intercompany transactions. Thus, this
eliminates one of the key advantages of creating the SPE. The following provides
additional guidance on SPE consolidation:

· EITF Issue 98-6, Investor's
Accounting for an Investment in a Limited Partnership When the Investor Is the Sole
General Partner and the Limited Partners Have Certain Approval or Veto Rights.

The primary consideration in
determining consolidation is identifying who maintains control of the SPE. EITF Topic D-14
states that nonconsolidation of SPEs and sales recognition related to SPE transactions are
not appropriate by the sponsor when:

· The majority owner of the SPE
makes only a nominal capital investment

· The activities of the SPE are
virtually all on the sponsor's or transferor's behalf

· The substantive risks and
rewards of the assets or the debt of the SPE rest directly or indirectly with the sponsor.

If the sponsor is the transferor
of the financial assets and the SPE meets the qualifying criteria, the sponsor
can still avoid consolidation, even if the EITF Topic D-14 and related guidelines are not
met. Statement of Financial Accounting Standards (SFAS) 140 details these criteria. SFAS
94 provides primary guidance regarding consolidation principles and focuses on control of
the entity. Though the remaining guidance is specific to leasing SPEs, it is consistently
used in determining consolidation of all SPE types.

The following issues should be
considered when evaluating the consolidation of SPEs:

· Is the capitalization of the
SPE adequate at all levels, particularly when (1) multi-tiered SPE structures are
utilized, (2) assets held by the SPE are volatile, and/or (3) derivatives are used? ·
Does the owners interest represent a residual equity interest in legal form?

· Is the equity holder truly
subordinate to the debt holders? · How are profits and losses allocated? Does the equity
holder have both upside and downside potential?

· Is the equity investor an
independent third party? · Who has actual control over the management and activities of
the SPE? · Are the risks and rewards of ownership retained by the third-party equity
investor for the entire term of the SPE?

The following issues should be
considered when evaluating the consolidation of SPEs:

· Is the capitalization of the
SPE adequate at all levels, particularly when (1) multi-tiered SPE structures are
utilized, (2) assets held by the SPE are volatile, and/or (3) derivatives are used? ·
Does the owners interest represent a residual equity interest in legal form? · Is
the equity holder truly subordinate to the debt holders?

· How are profits and losses
allocated? Does the equity holder have both upside and downside potential? · Is the
equity investor an independent third party?

· Who has actual control over
the management and activities of the SPE?

· Are the risks and rewards of
ownership retained by the third-party equity investor for the entire term of the
SPE?

The staff of the American
Institute of Certified Public Accountants (AICPA) has prepared a toolkit for accountants
and auditors, titled Accounting and Auditing for Related Parties and Related Party
Transactions. Though not authoritative, the publication was reviewed by the AICPA
Audit and Attest Standards staff and is intended to provide an overview of selected
accounting and auditing literature, SEC requirements and best-practice guidance concerning
related parties and related party transactions. Specific sections apply to
SPEs.

The decision to set it at 3% 3% (now 10% after FASB Interpretation
46 in January 2003) is arbitrary, but as Denny Beresford pointed out, there is a rationale for setting it
small since most SPEs are intended to be enormous projects (such as a pipeline) in which
even 3% (now 10%) is a lot of money.

I think that some outsider equity (e.g., 3% (now
10%) is required to cushion value changes of the SPE's assets agains value changes of the
SPE's debt. It is my understanding that the SPE should generally have valued assets (let's
call it "skin" for reasons explained below) equal to or greater than the value
of the debt. The theory is that debt risk is thereby covered, and off-balance-sheet
treatment of special projects is thereby covered --- and there can be theoretical and
financing reasons for keeping special projects off the consolidated balance sheet.

In theory, the assets of the SPE should have
"skin" in the sense that they are also assets that would appear on the
consolidated balance sheet if the SPE was consolidated. For example, if General Electric
decided to build a pipeline across Africa, GE could co-sign billions in debt/leases of an
SPE. The SPE would then borrow the cash and commence to build the pipeline. The SPE's
assets would be cash, land, pipes, etc. These have "skin."

The infamous Enron whistle blower (Ms. Watkins),
who sent anonymous letters to CEO Ken Lay and Andersen top brass, pointed out that most of
the Enron SPEs set up by CFO Fastow "had no skin." By this she meant that the
SPE assets were simply Enron stock certificates instead of being cash, land, pipes, and
other assets that would be assets if the SPEs were consolidated. Enron, however, could not
book its own common stock as an asset. You can read Ms. Watkins wording at http://www.trinity.edu/rjensen/fraud.htm#Hoax

As long as Enron's stock was above $80 per share,
the "value" of the stock in the Enron SPEs exceeded the current value of the
debt that was secretly being kept off Enron's consolidated balance sheets. However, when
Enron's share prices took a nose dive, the current value of the SPEs' debt greatly
exceeded the value of the SPEs' Enron shares and everything imploded to Enron's ground
zero. Had there be some real "skin" other than Enron's shares to offset the
value of the debt, Enron would not have imploded.

Hence, just because a company has SPEs does not
mean that there is a high risk of imploding like Enron. The values of the SPEs'
"skins" are what you need to investigate to evaluate the real underlying risk.

Enron was just too thin skinned in most of its
3,000+ SPEs.

What may be missing in accounting for an SPE may
be the continual monitoring of fair value of real skin that should not fluctuate wildly in
value (unlike Enron share values used as skin).

You really don't mind if you co-signed your kid's
second mortgage on a house as long as the value of the house is much higher than the
balance on that note payable. In case of default, you should get most of your money back
even if your kid only has 3% (now 10%) invested of his or her own money. This sort of SPE
is not so troublesome.

But if you co-sign to pay for your kid's college
education, and the kid does poorly and flunks out in the senior year, then you may get
nothing in the case of loan default. This sort of SPE should be booked all along as your
debt.

Maybe this issue has been raised
before and I have missed it. Pardon my ignorance, but I am somewhat unclear about the
rationale for the 3% (now 10%) rule. In one of the bookmarks in Bob Jensen's library (the
one dealing with SPEs), it is mentioned that "according to the accounting regulation,
the company establishing the SPE can contribute the remaining 97% and it still qualifies
for off- balance sheet treatment." Why 3% (now 10%) and not say 5% or 25%? What is
the logic behind the 3% (now 10%) rule? Can consolidation be avoided even though there is
control?

George Lan
University of Windsor

Murat's Reply to Kevin's Reply on April 11, 2002

Kevin:

Your questions are excellent and
as I read the internal memos of Andersen auditors either they did not dare to ask the
question or were mired down in GAAP detail. As I recall, SPEs first started with
securitizing receivables (mortgage notes) where an SPE simply buys the receivables and
sells to outside investors in bundles then transfers the collections (purchase price) to
the transferor. Thus, cash is coming in from an outside entity. In Enron's case there is
no cash coming in from outside plus Fastow and company do not have capital to underwrite
the risk. Enron is putting the assets their own stock [it would not have mattered if it
was some other company's stock or Enron's cash! All Fastow is doing is giving Enron the
wiggling room in accounting to get liabilities off balance sheet at a price. When no risk
is transferred why is Enron getting into this deal is the question auditors should be
asking rather than all the GAAP rules! In my opinion this is fraudulent.

On Bob's excellent web page, http://www.trinity.edu/rjensen/fraud021402.htm
he comments, "In theory, the assets of the SPE should have "skin" in the
sense that they are also assets that would appear on the consolidated balance sheet if the
SPE was consolidated. For example, if General Electric decided to build a pipeline across
Africa, GE could co-sign billions in debt/leases of an SPE. The SPE would then borrow the
cash and commence to build the pipeline. The SPE's assets would be cash, land, pipes, etc.
These have 'skin.' "

This is the only argument I've
seen that specifically would indicate that Enron's SPEs were not in compliance with GAAP.

What is the source of this
criterion? In the internal Andersen documents, even those written by Bass, this is not
mentioned, and I wonder why none of them seemed to be aware of it.

I've been out of financial
accounting for a while, but short of this criterion, other arguments that these
transactions were not consistent with GAAP from a measurement point of view seem easily
contestable (which I'd be glad to discuss), and changes the discussion to a debate about
how 'clear' the notes are (e.g., I DO see mention of the $500 million in income impacts in
note 16-a big red flag that Watkins mentions on p.7 #6 of her infamous memo to Lay).

Sure, Fastow was a related entity
who was enriched to the tune of tens of millions of dollars, but despite the tone of the
Board of Directors report, that's small potatoes from a measurement point of view, and a
cost of this magnitude certainly would not justify bringing down Andersen, nor would such
costs in themselves lead to the failure of Enron. Put another way, Enron would have
collapsed just as quickly if an independent party had been doing the deals for huge fees
because of the economic structure of the deals.

If the transaction were
potentially in compliance with GAAP, we'd be in the unusual situation where the client
complied with GAAP in a way that was materially misleading. If this is the case, based on
an earlier thread re: the problems auditors have had in withholding opinions in these
situations, maybe the profession at large is more culpable than Andersen.

So again, what is the source of
this criterion and what basis do we have for holding Andersen to it?

The lease must also meet the
requirements of FAS 98 and FASB's Emerging Issues Task Force (EITF) 90-15.

FAS 98 relates to properties
owned by a company, then sold and leased back. Such sales-leasebacks cannot be set up with
a purchase option at the end of the lease term. Therefore, the synthetic lease must be
arranged so that the title of the newly acquired property doesn't pass through the hands
of the lessor. Ensuring this will allow the company to avoid having to comply with FAS 98.

EITF 90-15 requires that
partnerships, special-purpose corporations, or trusts with assets must have equity capital
of at least 3 percent of the asset
value.

So, if these and, in certain
situations, other accounting rules are followed, the lease will meet the technical
requirements for operating leases, and the property can be kept off the company's balance
sheet.

But because the lessee controls
the appreciation of the property and is liable for depreciation, the IRS sees a synthetic
lease as a conditional sale, with the lessee entitled to the tax benefits of ownership.
So, for accounting purposes the property is owned by the lessor, and for tax purposes the
property is owned by the lessee.

The leases may be "more
appropriate for public companies," Berman says, although smaller companies planning
to go public are also using the product. "It has the most powerful impact for public
companies because one of the advantages of the lease is that it removes the depreciation
expense of ownership from the company's income statement, so it's an earnings
enhancer."

Synthetic Lease
Treatment At A Glance
Book And Tax Accounting

Book Accounting

Tax Accounting

Transaction
Structure:

Operating
lease

Conditional
sale

Owner:

Lessor

Lessee

Reason
for Classification:

Meets
FAS 13

Lessee
primarily retains risks and rewards of ownership

Expense
Item for Lessee:

Rent

Interest
and depreciation

Source: Key Global Finance

The FASB is on the defensive
in the Wake of Enron

FASB Chairman Edmund L. Jenkins Testifies Before Congressional Committee
(Mr. Jenkins is also a former executive partner in the Andersen accounting firm.)

Norwalk, CT, February 14, 2002In
testimony given today before the Subcommittee on Commerce, Trade, and Consumer Protection
of the House Energy and Commerce Committee, chaired by Representative Cliff Stearns
(R  FL), Financial Accounting Standards Board (FASB) Chairman Edmund L. Jenkins
outlined the FASBs role in setting U.S. accounting and financial reporting standards
and how they protect investors.

During his testimony, Mr. Jenkins
assured Chairman Stearns that the FASB "is prepared and committed to work with the
Subcommittee, the Securities and Exchange Commission (SEC) and all other constituents to
proceed expeditiously to resolve any and all financial accounting and reporting issues
that may arise as a result of Enrons bankruptcy."

Mr. Jenkins stated that the FASB,
like most others, "does not know many of the facts relating to Enrons financial
accounting and reporting." He added that Enron has publicly acknowledged in filings
with the SEC, and the findings confirmed by the Special Investigative Committee of
Enrons board of directors, that Enron did not comply with existing FASB standards in
at least two areas. In addition, there may be other possible violations of existing
requirements.

The FASB Chairman went on to
outline his groups ongoing work and projects aimed at providing significant
improvement to various current requirements, including the accounting for special-purpose
entities. Mr. Jenkins stated that the FASB has accelerated work on its consolidations
project and plans to issue proposed guidance relating to special-purpose entities in the
second quarter of this year. In response to concerns raised by SEC Chairman Harvey L. Pitt
and others about the speed of the FASBs standard-setting activities, he commented
that the FASB has undertaken several projects to improve its "efficiency and
effectiveness without jeopardizing the openness, thoroughness and effectiveness of our
open due process."

Mr. Jenkins pointed out that the
FASB has no authority or responsibility with respect to auditing, independence or scope of
service matters. As a result, the FASB and its accounting standards "cannot alone
sustain the transparency necessary to maintain the vibrancy of our capital markets. Other
market participants also must carry out their responsibilities in the public interest.
Those participants include reporting entities, auditors and regulators."

In pledging the FASBs best
efforts in that process, Mr. Jenkins concluded that "If anything positive results
from the Enron bankruptcy, it may be that this highly publicized investor and employee
tragedy serves as an indelible reminder to all of us that transparent financial accounting
and reporting do matter and that the lack of transparency imposes significant costs on all
who participate in the U.S. capital markets."

A copy of Mr. Jenkins remarks
is attached. The complete testimony filed with the Subcommittee on Commerce,
Trade, and Consumer Protection of the House Energy and Commerce Committee may be accessed
from the FASBs website, www.fasb.org.

About the
Financial Accounting Standards Board (FASB)

Since 1973, the Financial
Accounting Standards Board has been the designated organization in the private sector for
establishing standards of financial accounting and reporting. Those standards govern the
preparation of financial reports and are officially recognized as authoritative by the
Securities and Exchange Commission and the American Institute of Certified Public
Accountants. Such standards are essential to the efficient functioning of the economy
because investors, creditors, auditors and others rely heavily on credible, transparent
and comparable financial information. For more information about the FASB, visit our
website at www.fasb.org

This is a great opportunity for practioners to
show that they are interested in responding to FASB calls for comments. For example, do
you think the new EDs go far enough? How can we get airlines to book billions of dollars
in leased airplanes on the balance sheet? These EDs do not seem to do the job.

As influential House Energy Committee Chairman
Billy Tauzin called for a review of accounting rules "across the country and across
corporate boards," the Financial Accounting Standards Board continued its relentless
drive to strengthen the standards. On February 15, FASB announced the release of a revised
limited version of an exposure draft entitled Rescission of FASB Statements No. 4, 44, and
64 and Technical Corrections-Amendment of FASB Statement No. 13. The new ED proposes an
important change in lease accounting. http://www.accountingweb.com/item/72443

As described in the first ED,
companies will no longer be required to classify gains and losses from the extinguishment
of debt as extraordinary items, but they will still be allowed to use this accounting
treatment in certain circumstances.

As described in the new ED, the
accounting for certain types of leases will change, (i.e., sale-leaseback transactions and
lease modifications with economic effects similar to sale-leaseback transactions).

The reason for two EDs instead of
one is because the second has its roots in the comment letters for the first. Commentators
suggested changes they felt would improve financial reporting by eliminating
inconsistencies in the various standards. FASB agrees in theory. But it also recognizes
that some companies might have structured their leases differently, if the proposed
accounting changes had been in effect at the time of the transaction. To ensure these
substantive changes get a fair hearing, FASB decided to expose them for public comment as
part of its due process.

The item below may help you
when you send your letter to the FASB. Perhaps you should complain that the EDs do not go
far enough to correct abuses of accounting for synthetic leases.

On February 15, 2002, FASB announced http://accounting.rutgers.edu/raw/fasb/news/index.html
the release of a revised limited version of an exposure draft (ED) entitled Rescission of
FASB Statements No. 4, 44, and 64 and Technical Corrections-Amendment of FASB Statement
No. 13. The new ED supplements a previous ED dated November 15, 2001 and proposes an
important change in lease accounting. The FASB would like educators and
practitioners to respond to these new EDs.

From The Wall Street Journal's Accounting
Educator Reviews on January 24, 2002

SUMMARY: This article relates Enron's accounting
woes to the FASB's project on consolidation policy. Enron kept off its books by creating
separate entities which were excluded from the consolidated financial statements.

QUESTIONS:
1.) In the introductory paragraph to the article, the author states that the FASB is
debating the critical question of when, not whether, a company should be allowed to keep
its debt off its books. Do you think that is an accurate description of what the FASB
might be willing to do?

2.) Later in the article, the author makes it
clear that the question referred to above is one of "consolidating off-balance debt
and assets into the parent company's books." Go to the FASB web site's index of the
status of its technical projects ( http://accounting.rutgers.edu/raw/fasb/tech/index.html
). Describe their project entitled Consolidations-Policy and Procedures. In general, when
may an entity be excluded from consolidated financial statements? How must such an entity
be accounted for? What is meant by the term "special purpose entities"?

3.) One of the criticisms leveled against the
FASB in establishing this standard on consolidation policy is that the process is taking
much too long. Describe the FASB's due process in establishing accounting standards. How
does corporate America influence that process?

4.) Congress also is criticizing the FASB for not
standing up to its corporate constituents in areas in which corporations want to avoid
providing full disclosures. Yet Congress has in fact threatened the FASB with legislation
designed to slow down that process even further. Name two areas in which Congress has
represented corporate interests in dealing with the FASB.

5.) "FASB officials also point out not all
of Enron's problems were related to its off-balance-sheet debt. Some of [Enron's]
financial reporting violated basic accounting principles...indicating that the
problem...isn't so much with current standards as it is with compliance." Who is
responsible for maintaining compliance with current reporting standards? In general,
describe the current system for maintaining compliance with accounting and reporting
standards.

Harvey Pitt was Andersen's lawyer before he
heeded the call to public service just a few months ago to become Captain of the USS
SEC. He took command of the ship at a time when the beleaguered Big Five accounting
firms had been terrorized by the former USS SEC Captain Osama Levitt and Osama's Chief
Accountant Omar Turner. Before being exiled to Heartbreak Hotel, Osama and Omar
inflicted grave damage on the Big Five public accounting firms. Jeremy Kahn puts it
this way:

The American
Institute of Certified Public Accountants (AICPA), the industry's professional
association, points out that accountants examine the books of more than 15,000 public
companies every year; they are accused of errors in just 0.1% of those audits.
But oh, the price of those few failures. Lynn Turner, former chief accountant of the
Securities and Exchange Commission, estimates that investors have lost more than
$100 billion because of financial fraud and the accompanying earnings restatements since
1995.

Perhaps the most
glaring example of self-regulation's deficiency has been accountants' unwillingness to
deal with conflicts of interest. Over the years, the major auditing firms have
transformed themselves into "professional services" companies that derive an
increasing portion of revenues and profits from consulting: selling computer
systems, advising clients on tax shelters, and evaluating their business strategies.
In 1999, according to the SEC, half of the Big Five's revenues came from consulting fees,
vs. 13% (now 10%) in 1981.

...

"I think we had lots
of smoking guns," says former chairman Arthur Levitt. Two years ago the
accounting industry waged a bitter battle with Levitt over the issue of auditor
independence. He had considered asking the firms to curtail consulting, but backed
off after encountering stiff resistance from the accountants and their friends in
Congress.

Captain Pitt took over for Levitt with promises
to heal SEC relations with the Big Five by never challenging their fundamental rights of
the Big Five to serve management and investors simultaneously with both independent audits
of systems that their consulting family helped design and operate through consulting
practices.

Indeed, when it turned south, the USS SEC
may have become the Good Ship Lollipop in tropical waters had it not immediately crashed
into the Andersen Iceberg following the Enron scandal. For details of the Enron
scandal, see http://www.trinity.edu/rjensen/fraud.htm

Suddenly, Captain Pitt is overseeing a zero-sum
game of survival in which he must pick a winning side and a losing side. Whatever
the decision, powerful forces are going to fling him overboard to join his
predecessors in Heartbreak Hotel.

Scenario 1: Andersen Gets Hammered by the
SEC, and the SEC Sinks SPEs

If the SEC investigation finds the auditing firm severely negligent and in violation of
conflict of interest professionalism and he vows to put an end to the evil SPEs, Captain
Pitt will be an instant media hero, a beloved Captain who plucked Enron employees and
investors out of the thrashing sea and resuscitated their lives. But to do so,
Captain Pitt must turn on his former Andersen benefactors whom he served so diligently in
the past as a lawyer for their firm. Even worse, when he steps down from the SEC he
will be branded with a scarlet letter and banned for ever again being counsel to any
public accounting firm or corporation. In short, media heroes can still end up on
the floor of Heartbreak hotel.

Scenario 2: Andersen Gets Whitewashed by
the SEC, and the SEC Only Rearranges SPEDeck Chairs

If the SEC investigation finds Andersen's auditors to be noble and independent victims,
like the investing public and Enron's employees, of the dastardly greed of Enron's
pirates (Jeff Skilling, Andy Fastow, and Ken Lay), then Captain Pitt will be true to his
word and remain adored as a peach of a Captain by public accounting firms. He might
bestow upon them more than they'd hoped for when he took command of the USS SEC. But
his commission will be short lived. The powerful Chairman of the House Energy and Commerce
Committee, John Dingell (D-Mich.), will have this peach diced and sliced and then toss the
Pitt on the floor of Heartbreak Hotel. Former Captain Harvey Pitt will be so
maligned in the media that he will be blacklisted and possibly disbarred.

Of course there are other scenarios that are less
extreme, but it would seem that passions run too high in the Enron scandal. The
Enron collapse ruined the lives of too many people for Harvey Pitt to avoid ending up on
the floor of Heartbreak Hotel. Of course this will greatly please Osama Levitt and
Omar Turner in the Heartbreak Hotel. If he brings along his own Chief Accountant,
Bob Herdman, they will at last have four for games of contract bridge.

Harvey Pitt is in for the fight of his
life. In my opinion, SPEs are so important to companies worldwide that the
SEC, the FASB, the IASB, and virtually all other standard setters dare not go to battle
with industry over SPEs or substitutes, by whatever names, that allow certain types of
debt to stay off the balance sheets.

Dingell Takes Pitt to Task in
Wake
Of Enron Debacle; Full Investigation Sought

Rep. John Dingell (D-Mich.) Dec. 5 strongly questioned the "tenor and
tone" of Securities and Exchange Commission Chairman Harvey Pitt's recent remarks
that of late, his agency has not "always been a kinder and gentler place for
accountants."

"Your choice of words sends the wrong
message to auditors, to the SEC staff, and to the investing public," the Michigan
Democrat charged. He said that notwithstanding Pitt's prior legal representation "of
a substantial segment of the accounting profession," he expects a thorough SEC
investigation of the Enron matter--as well as "any and all other matters involving
your former clients."

Dingell included with his letter, released Dec.
6, a list of 16 accounting questions related to Enron that he asked Pitt to consider in
the course of the SEC's investigation. The questions addressed Enron's "complex
web" of off-balance sheet special-purpose entities, as well as "insider"
stock sales and Enron's 401(k) retirement plan. Dingell's final inquiry: "Who
profited from Enron's complex business structure. Where did all the money go?"

Enron, a Houston-based energy-trading company,
filed for Chapter 11 bankruptcy Nov. 30 after its stock price collapsed. In recent weeks
Enron acknowledged that between 1997 and the third quarter of 2001, it overstated profits
by some $586 million. The scope of regulatory inquiry into the collapse is said to include
Big Five accounting firm Andersen LLP's audit work for the troubled company.

Wrong Message

In his letter, Dingell harkened back to Pitt's first address as SEC chairman, in which he
heralded a "new era" of cooperation with the American Institute of Certified
Public Accountants (33 SRLR 1553, 10/29/01). In that address, Dingell noted, Pitt
"observed to an audience of accountants that the SEC 'has not, of late, always been a
kinder and gentler place for accountants.' "

"After noting your
representation of the AICPA and each of the Big Five accounting firms for the past two
decades," Dingell continued, "you lamented that 'somewhere along the way,
accountants became afraid to talk to the SEC, and the SEC appeared to be unwilling to
listen to the profession,' and you vowed that 'those days are ended.' "

"I am deeply troubled by the
tone and tenor of your remarks," Dingell, who is ranking member of the House Energy
and Commerce Committee, stated. "Your choice of words sends the wrong message to
auditors, to the SEC staff, and to the investing public."

In particular, the lawmaker said,
Pitt's message "appears to be that the rules will not be implemented as vigorously as
they should be. I trust that this is not what you meant to convey and that you will
correct any misunderstanding at the earliest possible time. This is critical, given the
plummeting confidence of investors in the integrity of financial reporting at this
time."

High Mark at Agency

In other remarks, Dingell told Pitt that he "may choose to repudiate the legacy of
your predecessor, Arthur Levitt. But make no mistake about it," Dingell asserted,
Levitt's tenure, "and that of his team on these issues--former Chief Accountant Lynn
Turner and former Director of Enforcement Richard Walker--represent a high mark at the SEC
in fighting financial fraud, and the standard against which you will be measured.
Notwithstanding your prior representation of a substantial segment of the accounting
profession," Dingell emphasized, "I expect you and your agency to conduct a
vigorous and fair investigation of the Enron matter and of any and all other matters
involving your former clients."

In connection with the foregoing,
Dingell commented that committee Chairman W.J. "Billy" Tauzin (R-La.). has
opened an investigation into the collapse of Enron and the events that led up to it, with
a view toward hearings next year. Saying he intends to participate in the bipartisan
probe, Dingell asked Pitt to consider a number of questions in connection with the SEC's
investigation that he--Dingell--"will seek answers to at an appropriate time."

SEC Response

In a Dec. 6 letter responding to Dingell's concerns, Pitt said he is "at a complete
loss" as to why the lawmaker found his remarks "about working with, and
listening to, the accounting profession ... troubling." Apologizing "for what
must have been a lack of articulateness," Pitt said he did not intend to suggest that
securities laws and regulations will not be vigorously enforced.

"Vigilant enforcement,
however, is not inconsistent with openness and accessibility," the SEC chief stated.
Saying the government, "and the SEC in particular, ... must be a service
industry," Pitt said that in the past, those the commission works with, including the
regulated community, have found the agency unapproachable--"or even outright
hostile."

"I am determined to change
that course of action and to renew or repair relationships that have been harmed in the
past," Pitt told Dingell. He said the commission's "adversarial attitude"
toward industry and the profession in recent hears has not yielded positive results.
"Indeed," he wrote, "we are seeing evidence of problems with the prior
Commission's approach in the matters you cited, which the current Commission is now
compelled to investigate."

Finally, Pitt thanked Dingell for
the questions he posed regarding the committee's inquiry into the Enron situation.
"We look forward to responding to your, and the Committee's, questions at an
appropriate time," Pitt advised.

At a committee hearing on the Enron debacle,
Hollings called for legislation to eliminate the use of special-purpose
entities, which are partnerships or trusts through which companies keep their
debt off the books and, in Enron's case, overstate earnings.

Hollings said such off-the-balance-sheet
transactions should end in order to protect investors. Hollings also was highly critical
of the amount of insider stock selling by top Enron officials. He noted that Enron
Chairman Kenneth Lay and former Chief Executive Jeffrey Skilling each sold shares in
recent months for more than $60 million, while members of Enron's board sold shares worth
more than $160 million.

If Enron officials felt the stock was
undervalued, as they publicly attested, "why were they cashing in?" Hollings
said.

Hollings also said there was plenty of blame for
the "shenanigans" associated with Enron's collapse, which he likened to a
"cancer." He cited Enron's role in persuading the Commodity Futures Trading
Commission against the Clinton administration's call for regulation of energy derivatives,
and subsequent congressional action to exempt from regulation the highly complex energy
derivatives Enron's special-purpose entities engaged in.

"We are all guilty for letting it
happen," Hollings said of Enron's collapse.

Sen. Byron Dorgan, D-N.D., chairman of the
committee's consumer affairs panel, described Tuesday's hearings as the first of several
that will delve into the roles in Enron's financial collapse played by: Enron officials;
Arthur Andersen, Enron's outside auditor; Wall Street analysts, and regulators.

"This is about an energy company that
morphed into a trading company involved in hedge funds and derivatives. It took on
substantial risks, created secret off-the-books partnerships and, in effect, cooked the
books under the nose of their accountants and investors," Dorgan said.

Dorgan noted that Lay, Enron's chairman and chief
executive, has agreed to testify at a future hearing. Dorgan also said the committee will
invite Skilling, Enron's former chief executive, and Andrew Fastow, Enron's former chief
financial officer, to testify at the same hearing.

"Was this just bad luck, incompetence and
greed, or were there some criminal or illegal actions, as has been suggested by the
accounting firm that reviewed Enron's books?" Dorgan said.

A Message on January 8, 2002 from Dennis
Beresford, former Chairman of the Financial Accounting Standards Board

I understand the SEC will
probably also tell companies that they need to enhance their MD&A disclosures about
special purpose entities.

Denny

Joe Beradino is the CEO of the auditing firm
(Andersen, Arthur Andersen, AA) that audited Enron for years prior to and during the
sudden meltdown of Enron in late 2001. Mr. Beradino tended to blame SPEs for much of
the problems in Enron's audited financial statements.

As the rules stand today,
sponsoring companies can keep the assets and liabilities of SPEs off their consolidated financial statements, even though they retain a
majority of the related risks and rewards. Basing the accounting rules on a risk/reward
concept would give investors more information about the consolidated entity's financial
position by having more of the assets and liabilities that are at risk on the balance
sheet; certainly more information than disclosure alone could ever provide. The profession
has been debating how to account for SPEs for many years. It's time to rethink the rules.

Modernizing our broken
financial-reporting model. Enron's collapse, like the dot-com meltdown, is a reminder that
our financial-reporting model -- with its emphasis on historical information and a single
earnings-per-share number -- is out of date and unresponsive to today's new business
models, complex financial structures, and associated business risks. Enron disclosed reams
of information, including an eight-page Management's Discussion & Analysis and 16
pages of footnotes in its 2000 annual report. Some analysts studied these, sold short and
made profits. But other sophisticated analysts and fund managers have said that, although
they were confused, they bought and lost money.

Quote From a Chief
Accountant of the SEC
(Well Over a Year Before the Extensive Use of SPEs by Enron Became Headline News.)

So what does this information tell
us? It tells us that average Americans today, more than ever before, are willing to place
their hard earned savings and their trust in the U.S. capital markets. They are willing to
do so because those markets provide them with greater returns and liquidity than any other
markets in the world and because they have confidence in the integrity of those markets.
That confidence is derived from a financial reporting and disclosure system that has no
peer. A system built by those who have served the public proudly at organizations such as
the Financial Accounting Standards Board ("FASB") and its predecessors, the
stock exchanges, the auditing firms and the Securities and Exchange Commission
("SEC" or "Commission"). People with names like J.P. Morgan, William
O. Douglas, Joseph Kennedy, and in our profession, names like Spacek, Haskins, Touche,
Andersen, and Montgomery.

But again, improvements can and should be made.
First, it has taken too long for some projects to yield results necessary for high quality
transparency for investors. For example, in the mid 1970's the Commission asked the FASB
to address the issue of whether certain equity instruments like mandatorily redeemable
preferred stock, are a liability or equity? Investors are still waiting today for an
answer. In 1982, the FASB undertook a project on consolidation. One of my sons who was
born that year has since graduated from high school. In the meantime, investors are still
waiting for an answer, especially for structures, such as special purpose entities (SPEs) that have been specifically designed with the aid of
the accounting profession to reduce transparency to investors. If we in the public sector
and investors are to look first to the private sector we should have the right to expect
timely resolution of important issues.

Enron's auditor, Andersen, blames most of the
misleading reporting regarding risk on unconsolidated special purpose entities (SPEs) that only require an outside equity interest of
3% (now 10%) to justify keeping the SPE's assets and liabilities from
being consolidated on the parent's balance sheet. Enron kept entire power plants and
millions of debt off the balance sheet with various SPE arrangements.

This begs the question of why SPEs are allowed
when the net effect is to possibly mislead investors about risk by keeping huge amounts of
debt off the consolidated balance sheet. In my view, they were created as a ploy to
keep debt off the balance sheet when the Financial Accounting Standards Board (FASB)
started to get serious about preventing other ploys designed to keep debt off the balance
sheet. Particularly troublesome to companies wanting to keep debt off the balance
sheet was FAS 13 that required all financing leases to be booked on the balance sheet,
thereby, no longer allowing most financing leases from remaining off the consolidated
balance sheet.

In no way can the above reasoning be published as
a justification for SPEs in the official literature. Hence, it is necessary to look
to the official literature for justifications due to securitization and tax advantages.

"The Big Five Need to Factor in
Investors," Business Week, December 24, 2001, Page 32 --- http://www.businessweek.com/ (not free to download
for non-subscribers)

At issue are
so-called special-purpose entities (SPEs), such as Chewco and JEDI partnerships Enron used to get assets like power plants
off its books. Under standard accounting, a company can spin off assets --- an the
related debts --- to an SPE if an outside investor puts up capital
worth at least 3% (now 10%) of the SPE's total value.

Three of Enron's
partnerships didn't meet the test --- a fact auditors Arthur Andersen LLP missed. On
Dec. 12, Andersen CEO Joseph F. Berardino told the House Financial Services Committee his
accountants erred in calculating one partnership's value. On others, he says, Enron
withheld information from its auditors: The outside investor put up 3% (now 10%), but Enron cut a side deal to cover half
of that with its own cash. Enron denies it withheld any information.

Does that absolve
Andersen? Hardly. Auditors are supposed to uncover secret deals, not let them
slide. Critics fear the New Economy emphasis means auditors will do even less
probing.

The 3% (now 10%) rule for SPEs is also too lax.

To Andersen's
credit, it has long advocated a tighter rule. But that would crimp the Big Five's
clients --- companies and Wall Street. Accountants
have helped stall changes.

Enron's collapse
may finally break that logjam. Like it or not, the Big Five must accept new rules
that give investors a clearer picture of what risks companies run with SPEs.

The rest of the article is on Page
38 of the Business Week Article.

"Arthur Andersen: How Bad
Will It Get?" Business Week, December 24, 2001, pp. 30-32 --- http://www.businessweek.com/ (not free to download
for non-subscribers)

QUOTE 1
Berardino, a 51-year-old Andersen lifer, may find the firm's competence in auditing
complex financial companies questioned. While Andersen was its auditory, Enron's
managers shoveled debt into partnerships with Enron's own ececs to get it off the balance
sheet --- a dubious though legal ploy. In one case, says Berardino, hoarse from
defending the firm on Capitol Hill, Andersen's auditors made an "error in
judgment" and should have consolidated the partnership in Enron's overall
results. Regarding another, he says Enron officials did not tell their auditor about
a "separate agreement" they had with an outside investor, so the auditor
mistakenly let Enron keep the partnership's results separate. (Enron denies that the
auditors were not so informed.)

QUOTE 2
Enron says a special board committee is investgating why management and the board did not
learn about this arrangement until October. Now that Enron has consolidated such
set-ups into its financial statements, it had to restate its financial reports from 1997
onward, cutting earnings by nearly $500 million. Damningly, the company says more
than four years' worth of audits and statements approved by Andersen "should not be
relied upon."

But neither
proposal (plans proposed by SEC Commission Chairman Harvey L. Pitt) goes far enough.
GAAP, the generally accepted accounting principles, desperately need to be revamped to
deal with cash flow and other issues relevant in a fast-moving, high-tech economy.
The whole move to off-balance sheet accounting should be reassessed. Opaque
partnerships that hide assets and debt do not serve the interests of investors. Under heavy shareholder pressure from
the Enron fallout, El Paso Corp. just moved $2 billion in partnership debt onto the
balance sheet. Finally,
Pitt should consider requiring companies to change their auditors who go easy on them, as
we have seen time and time again.

The Big
Five Firms Join Hands (in Prayer?)
Facing up to a raft of negative publicity for the accounting profession in light of Big
Five firm Andersen's association with failed energy giant Enron, members of all of the Big
Five firms joined hands (in prayer?) on December 4, 2001 and vowed to uphold higher
standards in the future. http://www.accountingweb.com/item/65518

The American
Institute of Certified Public Accountants released a statement by James G. Castellano,
AICPA Chair, and Barry Melancon, AICPA President and CEO, in response to a letter
published by the Big Five firms last week that insures the public they will "maintain
the confidence of investors." --- http://www.smartpros.com/x32053.xml

This Statement replaces FASB Statement No. 125, Accounting
for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. It
revises the standards for accounting for securitizations and other transfers of financial
assets and collateral and requires certain disclosures, but it carries over most of
Statement 125s provisions without reconsideration.

This Statement provides accounting and reporting
standards for transfers and servicing of financial assets and extinguishments of
liabilities. Those standards are based on consistent application of a financial-components
approach that focuses on control. Under that approach, after a transfer of financial
assets, an entity recognizes the financial and servicing assets it controls and the
liabilities it has incurred, derecognizes financial assets when control has been
surrendered, and derecognizes liabilities when extinguished. This Statement provides
consistent standards for distinguishing transfers of financial assets that are sales from
transfers that are secured borrowings.

A transfer of financial assets in which the
transferor surrenders control over those assets is accounted for as a sale to the extent
that consideration other than beneficial interests in the transferred assets is received
in exchange. The transferor has surrendered control over transferred assets if and only if
all of the following conditions are met:

The transferred assets have been isolated from the
transferorput presumptively beyond the reach of the transferor and its creditors,
even in bankruptcy or other receivership.

Each transferee (or, if the transferee is a
qualifying special-purpose entity (SPE), each holder of its beneficial interests) has the
right to pledge or exchange the assets (or beneficial interests) it received, and no
condition both constrains the transferee (or holder) from taking advantage of its right to
pledge or exchange and provides more than a trivial benefit to the transferor.

The transferor does not maintain effective control
over the transferred assets through either (1) an agreement that both entitles and
obligates the transferor to repurchase or redeem them before their maturity or (2) the
ability to unilaterally cause the holder to return specific assets, other than through a
cleanup call.

This Statement requires that liabilities and
derivatives incurred or obtained by transferors as part of a transfer of financial assets
be initially measured at fair value, if practicable. It also requires that servicing
assets and other retained interests in the transferred assets be measured by allocating
the previous carrying amount between the assets sold, if any, and retained interests, if
any, based on their relative fair values at the date of the transfer.

This Statement requires that servicing assets and
liabilities be subsequently measured by (a) amortization in proportion to and over the
period of estimated net servicing income or loss and (b) assessment for asset impairment
or increased obligation based on their fair values.

This Statement requires that a liability be
derecognized if and only if either (a) the debtor pays the creditor and is relieved of its
obligation for the liability or (b) the debtor is legally released from being the primary
obligor under the liability either judicially or by the creditor. Therefore, a liability
is not considered extinguished by an in-substance defeasance.

This Statement provides implementation guidance
for assessing isolation of transferred assets, conditions that constrain a transferee,
conditions for an entity to be a qualifying SPE, accounting for transfers of partial
interests, measurement of retained interests, servicing of financial assets,
securitizations, transfers of sales-type and direct financing lease receivables,
securities lending transactions, repurchase agreements including "dollar rolls,"
"wash sales," loan syndications and participations, risk participations in
banker's acceptances, factoring arrangements, transfers of receivables with recourse, and
extinguishments of liabilities. This Statement also provides guidance about whether a
transferor has retained effective control over assets transferred to qualifying SPEs
through removal-of-accounts provisions, liquidation provisions, or other arrangements.

This Statement requires a debtor to (a)
reclassify financial assets pledged as collateral and report those assets in its statement
of financial position separately from other assets not so encumbered if the secured party
has the right by contract or custom to sell or repledge the collateral and (b) disclose
assets pledged as collateral that have not been reclassified and separately reported in
the statement of financial position. This Statement also requires a secured party to
disclose information about collateral that it has accepted and is permitted by contract or
custom to sell or repledge. The required disclosure includes the fair value at the end of
the period of that collateral, and of the portion of that collateral that it has sold or
repledged, and information about the sources and uses of that collateral.

This Statement requires an entity that has
securitized financial assets to disclose information about accounting policies, volume,
cash flows, key assumptions made in determining fair values of retained interests, and
sensitivity of those fair values to changes in key assumptions. It also requires that
entities that securitize assets disclose for the securitized assets and any other
financial assets it manages together with them (a) the total principal amount outstanding,
the portion that has been derecognized, and the portion that continues to be recognized in
each category reported in the statement of financial position, at the end of the period;
(b) delinquencies at the end of the period; and (c) credit losses during the period.

In addition to replacing Statement 125 and
rescinding FASB Statement No. 127, Deferral of the Effective Date of Certain Provisions
of FASB Statement No. 125, this Statement carries forward the actions taken by
Statement 125. Statement 125 superseded FASB Statements No. 76, Extinguishment of Debt,
and No. 77, Reporting by Transferors for Transfers of Receivables with Recourse.
Statement 125 amended FASB Statement No. 115, Accounting for Certain Investments in
Debt and Equity Securities, to clarify that a debt security may not be classified as
held-to-maturity if it can be prepaid or otherwise settled in such a way that the holder
of the security would not recover substantially all of its recorded investment. Statement
125 amended and extended to all servicing assets and liabilities the accounting standards
for mortgage servicing rights now in FASB Statement No. 65, Accounting for Certain
Mortgage Banking Activities, and superseded FASB Statement No. 122, Accounting for
Mortgage Servicing Rights. Statement 125 also superseded FASB Technical Bulletins No.
84-4, In-Substance Defeasance of Debt, and No. 85-2, Accounting for
Collateralized Mortgage Obligations (CMOs), and amended FASB Technical Bulletin No.
87-3, Accounting for Mortgage Servicing Fees and Rights.

Statement 125 was effective for transfers and
servicing of financial assets and extinguishments of liabilities occurring after December
31, 1996, and on or before March 31, 2001, except for certain provisions. Statement
127 deferred until December 31, 1997, the effective date (a) of paragraph 15 of Statement
125 and (b) for repurchase agreement, dollar-roll, securities lending, and similar
transactions, of paragraphs 912 and 237(b) of Statement 125.

This Statement is effective for transfers and
servicing of financial assets and extinguishments of liabilities occurring after March 31,
2001. This Statement is effective for recognition and reclassification of collateral and
for disclosures relating to securitization transactions and collateral for fiscal years
ending after December 15, 2000. Disclosures about securitization and collateral accepted
need not be reported for periods ending on or before December 15, 2000, for which
financial statements are presented for comparative purposes.

This Statement is to be applied prospectively
with certain exceptions. Other than those exceptions, earlier or retroactive application
of its accounting provisions is not permitted.

An Interpretation of IAS 27, Consolidated
Financial Statements and Accounting for Investments in Subsidiaries
Effective date: Annual financial periods beginning on or after 1 July 1999

SIC 12 addresses when a special purpose entity
should be consolidated by a reporting enterprise under the consolidation principles in IAS
27. The SIC agreed that an enterprise should consolidate a special purpose entity
("SPE") when, in substance, the enterprise controls the SPE.

Examples of SPEs include entities set up to effect a
lease, a securitisation of financial assets, or R&D activities. The concept of control
used in IAS 27 requires having the ability to direct or dominate decision making
accompanied by the objective of obtaining benefits from the SPE's activities. The
Interpretation provides example indications of when control may exist in the context of an
SPE. The examples involve activities of the SPE on behalf of the reporting enterprise, the
reporting enterprise having decision-making powers over the SPE, and the reporting
enterprise having rights to the majority of benefits and exposure to significant risks of
the SPE.

Some enterprises may also need to separately
evaluate the topic of derecognition of assets, for example, related to assets transferred
to an SPE. In some circumstances, such a transfer of assets may result in those assets
being derecognised and accounted for as a sale. Even if the transfer qualifies as a sale,
the provisions of IAS 27 and SIC-12 may mean that the enterprise should consolidate the
SPE. SIC-12 does not address the circumstances in which sale treatment should apply for
the reporting enterprise or the elimination of the consequences of such a sale upon
consolidation.

Until recently, off-balance-sheet
financing of real estate through so-called synthetic leases was viewed as an escape
vehicle from depreciation burdens useful only in isolated conditions. The arrangements
were contrived, the legal documents thick, the accounting risky. But several recent
developments have conspired to change all that.

Dozens of Silicon Valley companies have penned such deals in the past 36 months,
and such blue-chip companies as General Motors, General Electric, Eastman Kodak, and
AlliedSignal are now said to be testing the waters. And while the Financial Accounting
Standards Board may still redefine the accounting for some lease- holding special-purpose
entities as part of its consolidations project, banks and lessees are now creating legal
structures to limit that risk.

More significant, the $250 million synthetic
lease deal signed in December 1996 by Cisco Systems Inc., which brings its total off-
balance-sheet leases to $505 million, is not only one of the biggest synthetics done so
far, but also shows that such leases can be much more than an accounting sideshow. Indeed,
the San Jose, California-based networking- products giant's latest deal is an integral
piece of the company's corporate financing strategy.

Filling a Basic Need Cisco turned to synthetic
leases because it needed more space but didn't like the traditional options. When the
company grew to $382 million (in revenues) back in fiscal 1992, management knew it
wouldn't be long before the firm would run out of room. Sure enough, on completion of its
most recent fiscal year, ended July 26, Cisco was a $6.4 billion company with almost
11,000 employees.

How much space and where to get it were Cisco's
primary concerns. But David Rogan, treasurer of Cisco, found both standard types of
financing--a traditional lease or ownership- -unappealing. The first option, leasing
existing property or space built to order, carried a price tag of 500 to 600 basis points
in annual cash outlays above what the company would pay to own it. Yet ownership--either
through a long-term loan or with cash--was also unattractive. Real estate loans were
impossible to secure after the collapse of California's market in the early 1990s; Cisco
needed cash for acquisitions and research; and the company didn't fancy the hit to
reported earnings that would result from depreciation of the property.

Best of Both Worlds Instead, Cisco signed up for
three deals in three years for $255 million in lease financing with Sumitomo Bank Leasing
and Finance Inc. for several additions on its various sites for a total of about 2 million
square feet.

First developed on Wall Street in the late 1980s,
the structure allows an investment- grade company like Cisco to obtain 100 percent
financing of its property at its corporate borrowing rate and receive the tax benefits of
ownership, while avoiding the depreciation associated with straight ownership. Now such
leases are widely available from specialized leasing companies.

Synthetic lessees typically reserve the right to
buy the property at the end of the lease, extend the lease, or sell the property and take
any gain or loss in its value. Minimum deal size is approximately $10 million.

"This is a far better mousetrap than
corporations have had in the past, and they are now easier and cheaper to do as the
documentation becomes more standardized," says Todd Anson, a managing partner with
Bro-beck, Phleger & Harrison LLP, in San Diego, who helped structure Cisco's latest
deal. Typical legal and accounting bills on a synthetic lease run about $50,000 to
$100,000 now, he adds. That's about half what it was a few years ago.

A clarification to the Financial
Accounting Standards Board's Statement 140, brought on by concerns from the real estate
market, will be a balm for the U.S. real estate finance industry, which viewed the rule as
a threat to one of its major sources of capital, according to a Reuters report.

FAS 140 took effect on April 1. The board will issue its
clarification of the rule on Thursday, according to a board staff member.

The rule without the clarification was the source
of debate within the real estate finance industry because it precluded the use of a
special servicing company in a commercial mortgage loan securitization.

Lenders providing money to commercial real estate
development and construction resell their loans into bonds via securitizations. The
special servicer is needed to cost-effectively resell the loans into bonds because
investors buying the bonds want an entity that will actively deal with troubled loans
pooled into bonds.

FASB project manager Halsey Bullen told Reuters
that special-purpose entities created when real estate loans are resold will not be able
to actively manage loans pooled into bonds.

But, he said, ``it is okay for the the QSPE
(qualified special purpose entity) to write, at inception of the deal, a conditional call
option.''

FASB will introduce guidance Thursday and one
aspect of the guidance makes clear that such a call option would allow the special
servicer to choose to buy a loan or any asset that has met some pre-arranged standard such
as a default at fair value, said Bullen.

FASB has already approved it, Bullen told
Reuters. It will present it to the emerging issues task force and ask it to incorporate it
into accounting literature.

``The difficulty all along has been that it is
clear in FAS 140 an QSPE cannot have a choice of whether it can sell an asset. It is okay
for someone else to have that choice, acting for themselves and not as an agent for the
QSPE,'' Bullen told Reuters. He added that some new transactions backed by commercial
mortgage loans will likely be designed to include this kind of call option.

According to a press release issued by The Real
Estate Roundtable, an industry trade group, the ``fair value'' call option would ``permit
the sale of defaulted loans in securitization transactions, despite provisions in the
April 1 accounting standard (SFAS 140) that limit a special servicer's discretion to
dispose of an impaired loan in a CMBS (commercial mortgage-backed security) pool.''

According to The Wall Street Journal Heard on the
Street Column, Sylvan Learning Systems market value fell by approximately $200
million after the release of a Bears and Stearns report that criticized some of
Sylvans accounting practices. The report questioned Sylvans activities
involving separate not-for-profit and special purpose entities.
Sylvan contributed stock and cash to the entities, treated the contributions as deductions
which offset break-up fee income the firm received when it retracted its offer to acquire
National Education Corporation (NEC).

Discussion Questions

Q1: Why would Sylvan be able to treat the
contributions to the not-for-profit entities as expenses?

Q2: Why did Sylvan management structure the
transaction in this manner?

Q3: One analyst thought the net effect of this
transaction would be to reduce EPS by $0.05 per share. Why did the firm lose so much
value?

Q2: According to Sylvans chief executive,
the purpose of the transaction was to reduce taxable income.

Q3: There are several plausible explanations. It
is possible that the accounting maneuver signaled greater uncertainty regarding the
firms future cash flows. Although the short-run loss was $0.05 per share, in the
long run, the amount of the loss is possibly much greater.

October 1999
(Revised Tentative Guidance Released on October 12, 2001)

Note: The guidance in this Issue is
tentative and may be finalized if an amendment to FASB Statement No. 133, Accounting
for Derivative Instruments and Hedging Activities, is issued. The Board intends to
issue an Exposure Draft proposing an amendment of Statement 133 in the fourth quarter of
2001.

QUESTION

If a qualifying special-purpose entity (SPE)
under FASB Statement No. 140, Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities, holds a combination of debt or equity
securities and derivative instruments, is the investors beneficial interest in the
qualifying SPE automatically a hybrid instrument that contains an embedded derivative that
warrants separate accounting? Specifically, consider the two following examples where the
qualifying SPE issues beneficial interests that are accounted for as debt instruments.

A qualifying SPE holds EURO-denominated
variable-rate corporate bonds and a pay-floating-EURO and receive-fixed-U.S. dollar
foreign currency interest rate swap. Assume that the notional amount of the swap matches
the principal amount of the corporate bonds, that its repricing dates match those of the
bonds, and that the index on which the swaps variable rate is based matches the
index on which the bonds variable rate is based. An investor purchases a beneficial
interest issued by the qualifying SPE that is denominated in U.S. dollars and has a fixed
interest rate.

The question of whether a beneficial interest
issued by a qualifying SPE is debt or equity is outside the scope of Statement 133. An
investor must determine whether the beneficial interest issued by the qualifying SPE that
it holds is debt or equity. When the qualifying SPE issues beneficial interests that are
accounted for as debt instruments, the following guidance should be applied. For purposes
of the above examples, assume that the investor does not consolidate the qualifying SPE.

RESPONSE

No, the investors beneficial interest in
the qualifying SPE should not automatically be considered a hybrid instrument that
contains an embedded derivative that warrants separate accounting. Statement 133
Implementation Issues No. A20, "Application of Paragraph 6(b) regarding Initial Net
Investment," and No. D2, "Applying Statement 133 to Beneficial Interests in
Securitized Financial Assets," provides that an investor may conclude that the
beneficial interest in the qualifying SPE it holds is a derivative in its entirety because
it meets the criteria in paragraph 6 and related paragraphs of Statement 133. If those
criteria are not met, then a beneficial interest that is issued by a qualifying SPE must
be evaluated under paragraph 12 similar to any other security that may contain terms that
affect some or all of the cash flows required by the contract in a manner similar to a
derivative instrument. When performing this evaluation, an investor should focus on only
the terms and conditions of the beneficial interest and not the detailed holdings of the
qualifying SPE.

Paragraph 12 requires that an embedded derivative
be accounted for separately as a freestanding derivative instrument if the following
criteria are met: (a) the economic characteristics of the embedded derivative instrument
are not clearly and closely related to the economic characteristics and risks of the host
contract, (b) the hybrid instrument is not remeasured at fair value with changes in fair
value reported in earnings as they occur, and (c) a separate instrument with the same
terms as the embedded derivative instrument would meet the definition of a derivative
instrument subject to the requirements of Statement 133.

Paragraphs 60 and 61 provide additional guidance
for determining when a hybrid instrument contains an embedded derivative that is not
clearly and closely related to the host contract. For example, based on the guidance in
paragraph 60, if a beneficial interest is accounted for as a debt instrument that is not
measured at fair value with changes in value reported in earnings as they occur and
incorporates a return that is based on a risk type other than interest rates (such as an
equity-based return), the embedded derivative that incorporates the equity-based return
would not be clearly and closely related to the host contract and would be required to be
accounted for separately.

In Example 1, the investor holds a beneficial
interest with a payoff equal to a variable-rate bond based on LIBOR, which does not
contain an embedded derivative that warrants separate accounting under Statement 133. In
Example 2, the investor holds a beneficial interest with a payoff equal to a fixed-rate
bond, which does not contain an embedded derivative that warrants separate accounting
under Statement 133.

If a beneficial interest in a qualifying SPE is
not within the scope of Statement 133, the investor should consider the applicability of
paragraphs 14 and 362 of Statement 140, which require that retained interests in
securitizations in which the holder may not recover substantially all of its recorded
investment be subsequently measured like investments in debt securities classified as
available-for-sale or trading under FASB Statement No. 115, Accounting for Certain
Investments in Debt and Equity Securities.

The above response represents a tentative
conclusion. The status of the guidance will remain tentative until it is formally cleared
by the FASB and incorporated in an FASB staff implementation guide, which is contingent
upon an amendment of Statement 133 being issued. The Board intends to issue an Exposure
Draft proposing an amendment of Statement 133 in the fourth quarter of 2001. Constituents
should send their comments, if any, to Timothy S. Lucas, Derivatives Implementation Group
Chairman, FASB, 401 Merritt 7, P.O. Box 5116, Norwalk, CT 06856-5116 (or by e-mail to
derivatives@fasb.org by November 16, 2001.

AC 409 Business Combinations

Classifications either as Acquisitions or Uniting of Interests

Effective date: Periods commencing on or after 1 January
2000

This interpretation makes it clear that the
criteria that needs to be met to account for a business combination as a uniting of
interests are such that they will rarely be met. A business combination should be
accounted for as an acquisition, unless an acquirer cannot be identified. A uniting of
interest is likely to be a rare occurrence because in virtually all business combinations
an acquirer can be identified.

The statement on business combinations describes
the essential characteristics of a uniting of interests. An enterprise should classify a
business combination as an acquisition, unless all of these characteristics are present.
Even if all of the three characteristics are present, an enterprise should classify a
business combination as a uniting of interests only if the enterprise can demonstrate that
an acquirer cannot be identified.

All business combinations under the statement on
business combinations are either an acquisition or a uniting of
interests.

These include the following:

a) in substance, the activities of the SPE are
being conducted on behalf of the enterprise according to its specific business needs so
that the enterprise obtains benefits from the SPEs operation,

b) in substance, the enterprise has the
decision-making powers to obtain the majority of the benefits of the activities of the SPE
or, by setting up an autopilot mechanism, the enterprise has delegated these
decision making powers,

c) in substance, the enterprise has rights to
obtain the majority of the benefits of the SPE and therefore may be exposed to risks
incident to the activities of the SPE, or

d) in substance, the enterprise retains the
majority of the residual or ownership risks related to the SPE or its assets in order to
obtain benefits from its activities.

Predetermination of the ongoing activities of an
SPE by an enterprise (the sponsor or other party with a beneficial interest) would not
represent the type of restrictions referred to in the statement on consolidated financial
statements and accounting for investments in subsidiaries which preclude certain
subsidiaries from being consolidated.

Accordingly this Interpretation might require
some SPEs to be consolidated which are not presently consolidated.

On July 31, 2000, the Japanese
Institute of CPAs issued its Accounting Standards Committee Report No. 15, Guidelines
to Accounting by Transferors for Liquidations of Real Estate Using
Special-Purpose Entities.

In
Japan, since an act of liquidations of loans and real estates was enacted on September 1,
1998, loans and real estates have been actively liquidated by securitizations using
special-purpose entities. Although accounting standard for liquidations of loans is
addressed by BADC Accounting Standards for Financial Instruments, accounting
standards have been silent for liquidations of real estates.

The JICPA Accounting Standards Committee Report
15 establishes accounting rules for securitizations of real estates. The Report
adopts the "risk-and-reward approach" to transfers of real estates, rather than
"financial component approach," which was adopted in Accounting Standards
for Financial Instruments. Under the "risk-and-reward
approach," if transferors transfer almost all risks and rewards of the real estates
to transferees, such transfer should be accounted for as a sale of the real estate,
otherwise it should be accounted for as a borrowing transaction. For example, if the
transferor assumes repurchase obligation of the real estate, it should not derecognize the
real estate because almost all risks and rewards are not transferred to the transferee.

Because the bright line should be drawn on the
transfer of almost all risks, the Report states that if more than 5 percent of the risks
involved with the real estate retains in the transferor, such real estate should not be
derecognized from the balance sheet of the transferor. Reportedly, such "5
percent threshold" appears to have significant impact on real estate market.

The AcSB has agreed to harmonize
the CICA Handbook - Accounting with the new proposed US standard on consolidations. It is
likely the differences between the new US standard and current Canadian standards will be
relatively few and insignificant. It would be unfortunate to allow any differences to
persist, particularly as the enterprises most concerned about harmonization (i.e.,
Canadian SEC registrants) are also the most likely to encounter the remaining differences
between the standards. The US guidance on special purpose entities (SPEs) would be very
useful in Canada in the absence of any Canadian pronouncements on the issue at present and
would avoid forcing companies to disclose a GAAP difference that is difficult to explain.
Special purpose entities are entities with specific limits on their powers.

The AcSB has approved a project proposal to harmonize
current Canadian standards for consolidations with new US standards on this subject. The
FASB is currently considering how to proceed with its project after having determined in
January 2001 that there is not sufficient support from its Board members to proceed with a
final standard on consolidation policy or an exposure draft on SPEs.

The IASB is presently gathering information on
existing practices with a view to commencing a project on this subject.

SPECIAL REPORT
A Guide to Implementation of Statement 140 on Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities

Questions and Answers

(an update of the Special Report
on implementation of Statement 125)

Halsey G. Bullen
Victoria A. Lusniak
Stephen J. Young

Conditions That Constrain a Transferee

22. Question
Assuming that all of the other requirements of paragraph 9 are met, has a transferor
surrendered control over transferred assets if the transferee (that is not a qualifying
special-purpose entity (SPE)) is precluded from exchanging the transferred assets but
obtains the unconstrained right to pledge them?

22. Answer
The answer depends on the facts and circumstances. In a transfer of financial assets, a
transferee's right to both pledge and exchange transferred assets suggests that the
transferor has surrendered its control of those assets. However, more careful analysis is
warranted if the transferee may only pledge the transferred assets. Paragraph 9(b)
requires that the transferee have the right to pledge or exchange the transferred assets.
The Board's reasoning for that condition is explained in paragraph 161, which states that
the transferee has obtained control over the transferred assets if it can sell or exchange
the transferred assets and, thereby, obtain all or most of the cash inflows that are the
primary economic benefits of financial assets? As discussed in paragraphs 168 and 169, the
Board concluded that the key concept is the ability to obtain all or most of the cash
inflows, either by exchanging the transferred asset or by pledging it as collateral
(paragraph 169). Also, paragraph 29 explains that transferor-imposed contractual
constraints that narrowly limit timing or terms, for example, allowing a transferee to
pledge only on the day assets are obtained or only on terms agreed with the transferor,
also constrain the transferee and presumptively provide the transferor with
more-than-trivial benefits.

25. Question
Assume that the risk inherent in a commercial loan portfolio securitized through a
qualifying SPE increases because of adverse changes in an industry for which a
concentration of loans exists. Can the servicer, which may be the transferor, use
discretion to select which loans to sell back to itself (or to a third party) at fair
value in response to that increased risk or concentration?

25. Answer
No. A qualifying SPEs powers are restricted to those in paragraph 35 of Statement
140. A transferors or servicers having discretion to select which loans to remove to
reposition a portfolio is beyond those powers set forth in paragraph 35(d)(1) of Statement
140. Sale accounting would also be precluded under the provisions of paragraphs 9(c)(2),
54, and 86(a) of Statement 140 because such a power gives the transferor the unilateral
right to reclaim specific assets from the qualifying SPE.

26. Question
Can an SPE enter into certain types of derivative transactions at the time beneficial
interests are issued and still be qualifying?

26. Answer
Yes, but only if those transactions (a) result in derivative financial instruments that
are passive in nature and pertain10 to beneficial interests issued or sold to entitles
other than the transferor, its affiliates, or its agents; (b) do not create conditions
that violate the provisions of paragraphs 35(c)(2) and 35(d); and (c) provide in its
legal documents the powers of the SPE to enter into derivative transactions. Refer to
Questions 27 and 28.

To illustrate, a qualifying SPE
is precluded from entering into written options that provide the holder with an
opportunity to trigger a condition that enables the SPE to sell transferred assets under
circumstances inconsistent with the requirements of paragraph 35(d)(2) of Statement 140.

If an SPE enters into certain
derivative instruments, sale accounting is precluded, not because the SPE is not
qualifying, but because other provisions of paragraph 9 have not been met. Examples
of those instruments include:

Derivative instruments that preclude the
transferor from achieving legal isolation under paragraph 9(a)

Derivative instruments through which the
transferor retains effective control over the transferred assets under paragraph 9(c).

27. Question
Can an SPE be qualifying if it can enter into certain types of derivative transactions
subsequent to the time that beneficial interests are issued?

27 Answer
Generally, no. As discussed in Question 26, a qualifying SPE can enter into derivative
transactions at the time beneficial interests are issued under paragraph 35(c)(2) as
interpreted by paragraphs 39 and 40. However, a derivative entered into by the
qualifying SPE at the time beneficial interests were issued may only be replaced upon
occurrence of a pre-specified event or circumstance outside the control of the transferor,
its affiliates, or its agents (for example, a default by the derivative counterparty) as
specified in the legal documents that established the qualifying SPE.

28. Question
Can an SPE be considered qualifying if it has the power to enter into a derivative
contract that, in effect, would result in that SPEs selling assets with the primary
objective of realizing a gain or maximizing return?

28. Answer
No. Paragraph 35(d)(1) (as interpreted by paragraphs 42 and 43) limits a
qualifying SPEs ability to sell (or otherwise dispose of) noncash financial assets held by
it to situations where there is, or is expected to be, a decline by a specified degree
below the fair value of those assets when the SPE obtained them. Derivative instruments
designed to effectively realize gains would be inconsistent with this provision. Refer to
Questions 26 and 27.

29. Question
Can an SPE that is permitted to hold title to nonfinancial assets temporarily as a result
of foreclosing on financial assets be considered qualifying?

29. Answer
Yes. Holding servicing rights to financial assets that it holds is a permitted
activity for qualifying SPEs under paragraph 35(c)(5) (as interpreted by paragraph 41).
Paragraph 61 indicates that servicing includes executing foreclosure if necessary.
Therefore, an SPE that holds title to nonfinancial assets temporarily as a result of
executing foreclosure on financial assets in connection with servicing can be considered
qualifying.

30. Question
Can an SPE that holds an investment accounted for under the equity method be qualifying?

30. Answer
Generally not. Entities account for an investment in accordance with the equity
method if they have the ability to exercise significant influence over that investment as
described by paragraph 17 of APB Opinion No. 18, The Equity Method of Accounting for
Investments in Common Stock. Qualifying SPEs are limited to holding passive investments in
financial assets. Paragraph 39 of Statement 140 notes that investments are not passive if
through them . . . the SPE or any related entity . . . is able to exercise control or
significant influence . . . . However, that limitation does not apply to certain
investments that are accounted for (for example, under EITF Topic No. D-46, Accounting for
Limited Partnership Investments) in accordance with the equity method, even though the
investor does not have the ability to exercise significant influence. Refer to
Question 41.

31. Question
Credit card securitizations often include a removal-of-accounts provision (ROAP) that
permits the seller, under certain conditions and with trustee approval, to withdraw
receivables from the pool of securitized receivables. Does a transferors right to
remove receivables from a credit card securitization preclude accounting for a transfer as
a sale?

31. Answer
It depends on the rights that the transferor has under the ROAP. A ROAP that does
not allow the transferor to unilaterally reclaim specific assets from the qualifying SPE,
as described in paragraphs 35(d)(3), 51-54, and 87, does not preclude sale accounting.
Paragraph 86 provides examples of ROAPs that would allow the transferor to unilaterally
reclaim specific transferred assets and preclude sale accounting. Refer to Question
49.

32. Question
If a transferors retention of beneficial interests in financial assets transferred to a
non-qualifying SPE that cannot pledge or exchange its assets permits the transferor to
dissolve the SPE and reassume control of the assets at any time, is the transferor
precluded from accounting for the transfer as a sale?

32. Question
Yes, for two reasons. First, because the SPE cannot pledge or exchange the assets
(it is not a qualifying SPE) and this restriction provides the transferor with the more
than trivial benefit of knowing that the assets (which it is entitled to reacquire) must
remain in the SPE, sale accounting is precluded under paragraph 9(b).

Second, the transferors current
ability to dissolve the SPE and reassume control of the assets entitles it to unilaterally
cause the return of the transferred assets, which precludes sale accounting under
paragraph 9(c)(2).

33. Question
Can a fixed-maturity debt instrument, a commercial paper obligation, or an equity interest
be considered a beneficial interest in a qualifying SPE?

33. Answer
Yes. Paragraph 75 states that . . . beneficial interests may comprise either a
single class having equity characteristics or multiple classes of interests, some having
debt characteristics and others having equity characteristics. Paragraph 173
explains that:

Qualifying SPEs
issue beneficial interests of various kindsvariously characterized as debt,
participations, residual interests, and otherwiseas required by the provisions of those
agreements.

34. Question
Can a qualifying SPE assume the obligations of a transferor or the obligations of some
other entity?

34. Answer
While assuming the debt of another entity is not specifically among the permitted
activities of a qualifying SPE as described in paragraph 35, an SPE can issue beneficial
interests, including those in the form of debt securities or equity securities, and be
considered qualifying. Paragraph 364 defines beneficial interests as:

Rights
to receive all or portions of specified cash inflows to a trust or other entity, including
senior and subordinated shares of interest, principal, or other cash inflows to be
"passed-through" or "paid-through," premiums due to guarantors,
commercial paper obligations, and residual interests, whether in the form of debt or
equity.

If a lender legally releases the
transferor from being the primary obligor under a liability assumed by an SPE, the lender
is, in fact, accepting a beneficial interest in the assets held by that SPE in exchange
for the loan it previously held. Therefore, a qualifying SPE can issue beneficial
interests in the transferred financial assets that it holds to a lender and, in effect,
assume or incur a debt obligation. An example of such an assumption by a qualifying
SPE is found in Question 35.

35. Question
May a debtor derecognize a liability (without having to recognize another, similar
liability) if it transfers noncash financial assets to a qualifying SPE that assumes the
liability?

35. Answer
Yes, but only if the liability is considered extinguished under paragraph 16 and the
transfer of the noncash financial assets is accounted for as a sale under
paragraph 9.

A debtor may derecognize a liability if and only
if it has been extinguished. Paragraph 16 states that a liability has been extinguished if
either of the following two conditions is met:

The debtor pays the creditor and is relieved of
its obligation for the liability. The debtor is legally released from being the primary
obligor under the liability, either judicially or by the creditor. The transfer of assets
to a qualifying SPE would not, in most cases, constitute a payment to the creditor and,
therefore, would not meet the condition in paragraph 16(a) of Statement 140. However, the
debtor may extinguish its liability if, as a result of transferring the assets to the
qualifying SPE, the debtor is legally released from being the primary obligor under the
liability according to paragraph 16(b) of Statement 140. If the creditor?s legal release
is not obtained, the debtor should continue to recognize the obligation.

A debtor that is legally released from being the
primary obligor by the transfer of noncash financial assets may, nevertheless, be required
to recognize another, similar liability if it continues to recognize those noncash
financial assets that were transferred to the qualifying SPE. According to the provisions
of paragraph 12 of Statement 140:

If a transfer of financial assets in exchange for
cash or other consideration (other than beneficial interests in the transferred assets)
does not meet the criteria for a sale in paragraph 9, the transferor and transferee shall
account for the transfer as a secured borrowing with pledge of collateral (paragraph 15).

If all of the conditions of paragraph 9 are not
met for the transfer of noncash financial assets to the SPE (for example, because the SPE
is not qualifying and the provisions of paragraph 9(b) are not met), the entity will
continue to recognize those assets. That also will result in the entity?s recording an
obligation to pass through the cash flows from those transferred assets to the qualifying
SPE.

36. Question
Can a qualifying SPE simultaneously be a conduit for separate (that is, no commingling or
cross-collateralization) securitizations from more than one transferor? In other words,
can a ?condominium structure? be a qualifying SPE?

36. Answer
Yes, as long as the restrictive criteria of paragraph 35 are met. That guidance does not
prohibit a qualifying SPE from acting as a conduit for more than one securitization
transaction, even if the individual ?condominiums? (which are sometimes referred to as
?silos?) hold dissimilar financial assets. If a qualifying SPE serves as a conduit for
different transferors, each condominium is effectively a qualifying SPE. Therefore, each
transferor applies the consolidation guidance in paragraph 46 of Statement 140 to its
condominium. Refer to Question 60.

37. Question
Should a qualifying SPE be consolidated by the transferor or its affiliates?

37. Answer
No. Paragraph 46 states that ?a qualifying SPE shall not be consolidated in the financial
statements of a transferor or its affiliates? (emphasis added).

Paragraph 25 of Statement 140 permits a formerly
qualifying SPE that fails to meet one or more conditions for being a qualifying SPE to be
considered a qualifying SPE if it maintains its qualifying status under previous
accounting standards, does not issue new beneficial interests after the effective date,
and does not receive assets it was not committed to receive before the effective date.
Otherwise, a formerly qualifying SPE and assets transferred to it shall be subject to
other consolidation policy standards and guidance, and to all provisions of Statement 140.

Beneficial interest holders, sponsors, servicers,
and others involved with a qualifying SPE that are not affiliated with the transferor
should apply consolidation policy standards and guidance, including EITF Issue No. 90-15,
?Impact of Nonsubstantive Lessors, Residual Value Guarantees, and Other Provisions in
Leasing Transactions,? and EITF Topic No. D-14, ?Transactions involving Special-Purpose
Entities,? if appropriate, to determine whether they should consolidate a qualifying SPE.

38. Question
Should a transferor apply Statement 140?s consolidation provisions when determining
whether to consolidate a qualifying SPE if some or all of the transfers of financial
assets to that SPE are accounted for as secured borrowings under paragraph 9?

38. Answer
Yes. The conditions for sale accounting in paragraph 9 are irrelevant to determining
whether a transferee is a qualifying SPE and whether it should be consolidated.

The result of applying Statement 140 if financial
assets are transferred to a qualifying SPE in transactions that were accounted for by the
transferor as secured borrowings is that the qualifying SPE would not be consolidated by
the transferor and the assets transferred to the qualifying SPE would continue to be
recognized by the transferor because the conditions for sale accounting have not been met.

39. Question
If a transferor subsequently transfers all the equity interests in a previously
unconsolidated qualifying SPE to an unrelated third party, would that third party be able
to use Statement 140 as its basis for evaluating consolidation accounting?

39. Answer
No. Paragraph 46 of Statement 140 is limited to consolidation by the ?transferor or its
affiliates.? Since the third party is neither the transferor nor one of its affiliates,
consolidation policy standards and guidance, including the guidance in Issue 90-15 and
Topic D-14, should be used to determine whether consolidation is appropriate.

40. Question
Assume that an entity transfers financial assets to a qualifying SPE in a transaction that
meets the criteria for sale accounting. Should the transferor consolidate the qualifying
SPE if it retains more than 50 percent of the fair value of the beneficial interests
issued by the qualifying SPE?

40. Answer
No. Paragraph 46 provides that ?a qualifying SPE shall not be consolidated in the
financial statements of a transferor or its affiliates.? That provision does not make a
distinction based on the proportion of the qualifying SPE?s beneficial interests that are
retained by the transferor. However, paragraph 36 provides that if the transferor holds
more than 90 percent of the fair value of the beneficial interests, that would preclude
the SPE from being a qualifying SPE unless the transfer is a guaranteed mortgage
securitization.

41. Question
Assume that Company A holds a 30 percent ownership interest in Company B. Company A sells
5 percent of that interest in Company B to an SPE, thereby reducing its interest to 25
percent. Before and after the transfer, Company A accounts for its ownership interest in
Company B under the equity method. Use of the equity method under Opinion 18 presumes that
Company A has significant influence over Company B. Under Statement 140, Company A cannot
be a qualifying SPE if it holds investments that allow it or others to exercise control or
significant influence over the investee. Would Company A be precluded from applying the
consolidation guidance in Statement 140 to that SPE? Would it make a difference if Company
A?s ownership interest in Company B is reduced to a level such that the investment is no
longer accounted for under the equity method after the transfer?

41. Answer
Yes and perhaps, respectively.

Yes, Company A is precluded from applying the
consolidation guidance in Statement 140 to that SPE because the SPE is not a qualifying
SPE. A qualifying SPE may hold only passive instruments. Paragraph 39 explains that

Investments are not passive if through them,
either in themselves or in combination with other investments or rights, the SPE or any
related entity, such as the transferor, its affiliates, or its agents, is able to exercise
control or significant influence . . . over the investee.

However, if as a result of the transfer, the
transferor, the SPE, and any other related entities in combination cannot exercise
significant influence or control over the investee, and the SPE meets the other
requirements of Statement 140 to be a qualifying SPE, the transferor would apply the
consolidation provision of paragraph 46. Refer to Question 30.

Effective Control

42. Question
Dollar-roll repurchase agreements (also called dollar rolls) are agreements to sell and
repurchase similar but not identical securities. Dollar rolls differ from regular
repurchase agreements in that the securities sold and repurchased, which are usually of
the same issuer, are represented by different certificates, are collateralized by
different but similar mortgage pools (for example, conforming single-family residential
mortgages), and generally have different principal amounts. Is a transfer of financial
assets under a dollar-roll repurchase agreement within the scope of Statement 140?

42. Answer
A transfer of financial assets under a dollar-roll repurchase agreement is within the
scope of Statement 140 if that agreement arises in connection with a transfer of existing
securities.11 In contrast, dollar-roll repurchase agreements for which the underlying
securities being sold do not yet exist or are to be announced (for example, TBA GNMA
rolls) are outside the scope of Statement 140 because those transactions do not arise in
connection with a transfer of recognized financial assets. In those cases, other existing
literature should be applied. For example, the provisions of Statement 133 or EITF Issue
No. 84-20, ?GNMA Dollar Rolls,? may apply to what are considered Type 4 securities by that
Issue. Any type of Type 4 contracts that are not subject to Statement 133?s provisions
must be marked to market as required by Issue 84-20.

43. Question
Does paragraph 9(c)(1) preclude sale accounting for a dollar-roll transaction that is
subject to the provisions of Statement 140?

43. Answer
The answer depends on the facts and circumstances. For paragraph 9(c)(1) to preclude sale
accounting, pursuant to paragraph 47(a), ?the assets to be repurchased or redeemed [must
be] the same or substantially the same as those transferred.? Paragraph 48 describes six
characteristics that must all exist in order for a transfer to meet the
substantially-the-same requirement in paragraph 47(a). One of those characteristics is
that the same aggregate unpaid principal amount or principal amounts within accepted
?good-delivery? standards for the type of security involved must be met. However, the
good-delivery standard is only one of the six characteristics that must exist. Another is
that the transferor must be able to repurchase or redeem the transferred assets on
substantially the agreed terms, even in default by the transferee. Refer to Question 45.

44. Question
In a transfer of existing securities under a dollar-roll repurchase agreement, if the
transferee is committed to return substantially-the-same securities to the transferor but
that transferee?s securities were TBA (to be announced) at the time of transfer, would the
transferor be precluded from accounting for the transfer as a secured borrowing?

44. Answer
No. For transfers of existing securities under a dollar-roll repurchase agreement, the
transferee must be committed to return substantially-the-same securities to the transferor
to fail the condition in paragraph 9(c)(1) that would preclude sale accounting. The asset
to be returned may be TBA at the time of the transfer because the transferor would have no
way of knowing whether the transferee held the security to be returned. That is, the
transferor is only required to obtain a commitment from the transferee to return
substantially-the-same securities and is not required to determine that the transferee
holds the securities that it has committed to return.

45. Question
Paragraph 49 states that ?to be able to repurchase or redeem assets on substantially the
agreed terms, even in the event of default by the transferee, a transferor must at all
times during the contract term have obtained cash or other collateral sufficient to fund
substantially all of the cost of purchasing replacement assets from others.? Would the
requirement of paragraph 9(c)(1) preclude sale accounting by the transferor if, under the
arrangement, the transferor is substantially overcollateralized at the date of transfer
even though the arrangement does not provide for frequent adjustments to the amount of
collateral maintained by the transferor?

45. Answer
A mechanism to ensure that adequate collateral is maintained must exist even in
transactions that are substantially overcollateralized (for example, ?deep discount? and
?haircut? transactions) for paragraph 9(c)(1) to preclude sale accounting for those
transactions. Even if the probability of ever holding inadequate collateral appears
remote, as explained in paragraph 49, the requirement of paragraph 9(c)(1) would not be
met and sale accounting by the transferor would not be precluded unless the arrangement
assures, by contract or custom, that the collateral is sufficient ?at all times . . . to
fund substantially all of the cost of purchasing replacement assets from others.?

Statement 140 does not prescribe that a specific
contractual term, such as a margining provision, must be present to meet the sufficient
collateral requirement. Instead, Statement 140 prescribes, as explained in paragraph 218,
what the effect of the arrangement must be?that the transferor "is protected by
obtaining collateral sufficient to fund substantially all of the cost of purchasing
identical replacement securities during the term of the contract so that it has received
the means to replace the assets even if the transferee defaults." Simply excluding a
margining provision from a repurchase agreement does not change the accounting that
results if the maintenance of sufficient collateral is otherwise assured. For example, a
contractual provision that a repurchase agreement is immediately terminated should the
value of the collateral become insufficient to fund substantially all of the cost of
purchasing replacement assets would satisfy the requirement in paragraph 49.

46. Question
Paragraph 49 requires that ?. . . a transferor must at all times during the contract term
have obtained cash or other collateral sufficient to fund substantially all of the cost of
purchasing replacement assets from others? (emphasis added). Substantially all is not
specifically defined in Statement 140. Should entities analogize to APB Opinion No. 16,
Business Combinations, and interpret substantially all to mean 90 percent or more?

46. Answer
No. The Board elected not to define substantially all because, as explained in paragraph
218, ?judgment is needed to interpret the term substantially all and other aspects of the
criterion that the terms of a repurchase agreement do not maintain effective control over
the transferred asset.? Paragraph 218 further states:

. . . arrangements to repurchase or lend readily
obtainable securities, typically with as much as 98 percent collateralization (for
entities agreeing to repurchase) or as little as 102 percent overcollateralization (for
securities lenders), valued daily and adjusted up or down frequently for changes in the
market price of the security transferred and with clear powers to use that collateral
quickly in the event of default, typically fall clearly within that guideline. The Board
believes that other collateral arrangements typically fall well outside that guideline.

Judgment should be applied based on the facts and
circumstances.

47. Question
Does Statement 140 contain special provisions for differences in collateral maintenance
requirements that exist in markets outside the United States?

47. Answer
No. The general provisions of Statement 140 apply. Market practices and contracts for
repurchase, sale-buy backs, and securities lending transactions can vary significantly
from market to market and country to country. However, sale accounting is precluded by
paragraph 9(c)(1) only if the transfer involves an agreement that both entitles and
obligates the transferor to repurchase or redeem the assets before maturity and all of the
requirements of paragraphs 47-49 are met.

For example, in certain markets, it is not
customary to provide or maintain collateral in connection with repurchase transactions. In
addition, in emerging market repurchase agreements, the amount of cash lent often is
limited to an amount substantially less than 100 percent (for example, 80 percent or less)
of the value of the securities transferred under the repurchase agreements because of the
level of market and credit risk associated with those transactions. Statement 140 does not
provide special provisions for those differences in collateral requirements and, as a
result, sale accounting would not be precluded by paragraph 9(c)(1) for those
transactions.

48. Question
Paragraph 9(c)(1) of Statement 140 states that a transferor has surrendered control over
transferred assets if it does not maintain effective control over the transferred assets
through ?an agreement that both entitles and obligates the transferor to repurchase or
redeem them before their maturity . . .? (emphasis added). What does the term before
maturity mean in the context of the transferor maintaining effective control under the
provisions of Statement 140?

48. Answer
Statement 140 does not specifically define the term before maturity. However, in
describing whether a transferor maintains effective control over transferred assets
through a right and obligation to repurchase, paragraph 213 states that ?. . . the Board
concluded that the only meaningful distinction based on required repurchase at some
proportion of the life of the assets transferred is between a ?repo-to-maturity,? in which
the typical settlement is a net cash payment, and a repurchase before maturity, in which
the portion of the asset that remains outstanding is indeed reacquired in an exchange.? A
transferor?s agreement to repurchase a transferred asset would not be considered a
repurchase or redemption before maturity if, because of the timing of the redemption, the
transferor would be unable to sell the asset again before its maturity (that is, the
period until maturity is so short that the typical settlement is a net cash payment).

49. Question
How do different types of rights of a transferor to reacquire (call) transferred assets
affect sale accounting under Statement 140?

49 Answer
Sale accounting is precluded if a right to reacquire (call) a transferred asset12 has any
of three effects:

1. A condition both constrains the transferee
from taking advantage of its right to pledge or exchange the transferred asset(s) and
provides more than a trivial benefit to the transferor (paragraph 9(b)).

2. The transferor maintains effective control
through an agreement that both entitles and obligates it to redeem transferred asset(s)
before their maturity (paragraph 9(c)(1)).

3. The transferor maintains effective control
through the ability to cause, unilaterally, the return of specific transferred assets
(paragraph 9(c)(2)).13

A unilateral right to reclaim specific
transferred assets precludes sale accounting only for transferred assets that the
transferor has the unilateral right to reacquire. Paragraph 52 states that clearly: ?. . .
a call on specific assets transferred to a qualifying SPE . . . maintains that
transferor?s effective control over the assets subject to that call? (emphasis added).
Further, a right to reclaim specific transferred assets precludes sale accounting only if
the transferor can exercise the right unilaterally. The following table summarizes
Statement 140?s provisions for different types of rights of a transferor to reacquire
(call) transferred assets, including references to paragraphs in the Statement that
provide more detail.

A February 15, 2002 Message from Barbara Leonard,
Loyola University Chicago [BJBLeonard@AOL.COM]

Please let me know if I am wrong,
but I thought I heard Ms. Watkins say in her testimony that certain contracts to deliver
goods or services in the future were sold to the SPEs and then booked the investment in
the SPE at fair (market) value, or discounted future cash flows. According to GAAP, Enron
would have had to earn, or deliver the product before revenue recognition but simply
sidestepped this accounting principle by selling the contract to an investee and then
carryied the investee at "fair value." If so, I wonder how many other companies
are doing this and why we bother teaching GAAP anyway.

Is it possible to teach this transaction from an IFRS perspective?

Denny Beresford made a helpful suggestion that one way to teach IFRS is to
first look at the transaction itself and then reason out how to account for it
under IFRS standards and interpretations. So here's a challenge for your
advanced-level accounting students: How would you account for this one
under IFRS?

What this illustrates is the type of thing that the IASB will have to tackle
all alone, without a FASB research staff, when the U.S. depends upon the IASB
for its accounting standards. I don't think the IASB fully understands what it
is getting into by so desperately wanting to set accounting standards for U.S.
companies.

From the financial rounds blog on December 29, 2008

How Do You Use Credit Default Swaps (CDS) To Create "Synthetic Debt"?

There's been a lot of talk in recent months about
"synthetic debt". I just read a pretty good explanation of synthetics in
Felix Salmon's column, so I thought I'd give a brief summary of what it is,
how it's used, and why.

First off, let's start with Credit Default Swaps (CDS). A CDS has a lot of
similarities to an insurance policy on a bond (it's different in that the
holder of the CDS needn't own the underlying bond or even suffer a loss if
the bond goes into default).

The buyer (holder) of a CDS will make yearly payments (called the
"premium"), which is stated in terms of basis points (a basis point is 1/100
of one percent of the notional amount of the underlying bond). The holder of
the CDS gets paid if the bond underlying the CDS goes into default or if
other stated events occur (like bankruptcy or a restructuring).

So, how do you use a CDS to create a synthetic bond? here's the example from
Salmon's column:

Let's assume that IBM 5-year bonds were yielding 150 basis points over
treasuries. In addition, Let' s assume an individual (or portfolio manager)
wanted to get exposure to these bonds, but didn't think it was a feasible to
buy the bonds in the open market (either there weren't any available, or the
market was so thin that he's have to pay too high a bid-ask spread). Here's
how he could use CDS to accomplish the same thing:

First, buy $100,000 of 5-year treasuries and
hold them as collateral

Next, write a 5-year, $100,000 CDS contract

he's receive the interest on the treasuries,
and would get a 150 basis point annual premium on the CDS

So, what does he get from the Treasury plus writing
the CDS? If there's no default, the coupons on the Treasury plus the CDS
premium will give him the same yearly amount as he would have gotten if he's
bought the 5-year IBM bond, And if the IBM bond goes into default, his
portfolio value would be the value of the Treasury
less what he would have to pay on
the CDS (this amount would be the default losses on the IBM bond). So in
either case (default or no default), his payoff from the portfolio would be
the same payments as if he owned the IBM bond.

So why go through all this trouble? One reason might be that there's not
enough liquidity in the market for the preferred security (and you'd get
beaten up on the bid-ask spread). Another is that there might not be any
bonds available in the maturity you want. The CDS market, on the other hand,
is very flexible and extremely liquid.

One thing that's interesting about CDS is that (as I mentioned above), you
don't have to hold the underlying asset to either buy or write a CDS. As a
result, the notional value of CDS written on a particular security can be
multiple times the actual amount of the security available.

I know of at least one hedge fund group that bought CDS as a way of betting
against housing-sector stocks (particularly home builders). From what i
know, they made a ton of money. But CDS can also be used to hedge default
risk on securities you already hold in a portfolio.

To read Salmon's column, click
here, and to read more about CDS, click
here

Credit Default Swap (CDS)
This is an insurance policy that essentially "guarantees" that if a CDO goes bad
due to having turds mixed in with the chocolates, the "counterparty" who
purchased the CDO will recover the value fraudulently invested in turds. On
September 30, 2008 Gretchen Morgenson of The New York Times aptly
explained that the huge CDO underwriter of CDOs was the insurance firm called
AIG. She also explained that the first $85 billion given in bailout money by
Hank Paulson to AIG was to pay the counterparties to CDS swaps. She also
explained that, unlike its casualty insurance operations, AIG had no capital
reserves for paying the counterparties for the the turds they purchased from
Wall Street investment banks.

What Ms. Morgenson failed to explain, when Paulson eventually gave over $100
billion for AIG's obligations to counterparties in CDS contracts, was who were
the counterparties who received those bailout funds. It turns out that most of
them were wealthy Arabs and some Asians who we were getting bailed out while
Paulson was telling shareholders of WaMu, Lehman Brothers, and Merrill Lynch to
eat their turds.

Over the past few days, two very smart people have
asked me about a passage in Michael Lewis's cover story for
Portfolio in which he talks about synthetic CDOs without actually using
the term. They said that they didn't quite understand it, so I'm going to
try to explain what a synthetic bond is. Once I've done that, the Lewis
passage should be a lot more comprehensible.

Let's start with a simple single-credit synthetic
bond. You're an investor, and looking at the credit markets, you see that
IBM debt is trading at attractive levels, especially around the 5-year mark,
where they yield about 150bp over Treasuries. You'd really like to buy $100
million of IBM bonds maturing in five years, but IBM isn't returning your
calls (they have no desire to borrow money at these spreads), and there
aren't any IBM bonds with exactly the maturity you want. What's more, even
the bonds with maturities nearby are illiquid, and closely held: there's no
way you can just blunder into the market and buy up that many bonds without
massively skewing the market, since the overwhelming majority of the bonds
are just not for sale.

So you buy a synthetic IBM five-year bond instead,
taking advantage of the much more liquid CDS market. Essentially, you take
the $100 million that you were going to spend on IBM bonds, and you put it
into a special-purpose entity called, say, Fred. (In reality, it'll be
called something really boring like Synthetic Technology Invetments Cayman
III Limited, but Fred is easier to remember.) First, Fred takes the $100
million and invests it in 5-year Treasury bonds.

Next thing, Fred goes out and sells $100 million of
credit protection on IBM in the CDS market, using the $100 million of
Treasury bonds as collateral. The buyer of protection will pay $1.5 million
per year (150 basis points) to Fred, and in return Fred promises to pay $100
million to the buyer in the event IBM defaults, less the value of IBM's
bonds at the time. The buyer knows that Fred is good for the money, because
it's already there, tied up in Treasury bonds.

So long as IBM doesn't default, you get not only
the $1.5 million per year from the buyer of protection, but also the
interest on the Treasury bonds. You wanted to buy IBM bonds yielding 150bp
over Treasuries, and that's exactly what you're getting: the 150bp from the
CDS counterparty, and the Treasury interest from the Treasury bonds. At
maturity, assuming IBM still hasn't defaulted, you get your $100 million
back, the CDS contract has expired, and Fred has no contingent liability any
more.

The effect is identical to holding an IBM bond --
and you can even sell your interest in Fred, just like you could sell an IBM
bond. If IBM defaults, you lose your $100 million, but you get back the
value of an IBM bond -- which again is the same outcome as if you'd bought
an IBM bond for $100 million and IBM defaulted.

But the key thing to note is that IBM itself is not
involved in the transaction at all. It doesn't matter how few bonds IBM has
issued, there can be many times that amount in synthetic IBM bonds, just so
long as there are enough people out there willing to buy and sell credit
protection on IBM.

And just as you can create a synthetic IBM bond,
you can create a synthetic bond portfolio, made up of credit default swaps
on any number of corporate names or even mortgage-backed securities. The
special purpose vehicles in those cases sometimes sell protection on a lot
of different names; sometimes they just sell protection on a liquid CDS
index. Either way, the returns that those vehicles offer are basically the
same as the returns on buying the underlying securities -- if those
securities were easily available.

Now that we've understood all that, we can return
to Michael Lewis's piece, where he's talking about a chap called Steve
Eisman, who was buying protection in the CDS market, and is sat at dinner
next to one of his counterparties, who was selling protection.

Whatever rising anger Eisman felt was offset by
the man's genial disposition. Not only did he not mind that Eisman took
a dim view of his C.D.O.'s; he saw it as a basis for friendship. "Then
he said something that blew my mind," Eisman tells me. "He says, 'I love
guys like you who short my market. Without you, I don't have anything to
buy.'¿"
That's when Eisman finally got it. Here he'd been making these side bets
with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche
without fully understanding why those firms were so eager to make the
bets. Now he saw. There weren't enough Americans with shitty credit
taking out loans to satisfy investors' appetite for the end product. The
firms used Eisman's bet to synthesize more of them. Here, then, was the
difference between fantasy finance and fantasy football: When a fantasy
player drafts Peyton Manning, he doesn't create a second Peyton Manning
to inflate the league's stats. But when Eisman bought a credit-default
swap, he enabled Deutsche Bank to create another bond identical in every
respect but one to the original. The only difference was that there was
no actual homebuyer or borrower. The only assets backing the bonds were
the side bets Eisman and others made with firms like Goldman Sachs.
Eisman, in effect, was paying to Goldman the interest on a subprime
mortgage. In fact, there was no mortgage at all. "They weren't satisfied
getting lots of unqualified borrowers to borrow money to buy a house
they couldn't afford," Eisman says. "They were creating them out of
whole cloth. One hundred times over! That's why the losses are so much
greater than the loans. But that's when I realized they needed us to
keep the machine running. I was like, This is allowed?"

What Eisman is saying is that there were
mortgage-backed securities, and then there were synthetic mortgage-backed
securities; when the banks ran out of actual MBS to sell to investors, they
sold them synthetic MBS instead. And yes, that was allowed.

There is some hyperbole here, though. While there
were undoubtedly a lot of synthetic MBS issued, they weren't a large
multiple of the real MBS issued, as the "one hundred times over" quote would
suggest. Which is quite obvious, if you think about it: there weren't a lot
of people like Steve Eisman willing to short the MBS market -- and you need
them, to take the other side of the trade.

In fact, most of the synthetic MBS issued were
issued by banks which kept the underlying mortgages on their own balance
sheet. Rather than put the mortgages directly into a CDO and sell that to
investors, they kept the mortgages themselves and bought protection
from the CDO on them -- creating a synthetic CDO which mirrored
(and which they could sell to hedge) their own holdings. Why did they do
that? That's the story of the super-senior tranche, and will have to wait
for another day.